THE SPACE BETWEEN MARKETS AND HIERARCHIES
George S. Geis*
[Note to Workshop Participants: I am looking forward to discussing
these ideas on February 22. I also want to call your attention to the fact that
the last section (Part IV) is currently a work in progress. Thus, I am
particularly interested in your comments for this unfinished portion of the
project. Thanks, George]
The decision to pool production within a firm raises a fundamental
tension for corporate law scholars. On the one hand, channeling activity
into a centralized entity can economize on transaction costs by replacing
the hassles of arms-length contracting with managerial discretion. Instead
of attempting to write a complete contract to insulate against counterparty
opportunism, firm managers retain the control necessary to make optimal
decisions later—if and when a potential contingency arises. On the other
hand, agency costs and production costs may be somewhat higher when
business is conducted within a firm—because the activity is walled off from
the relentless pricing pressure that comes with well-functioning markets.
Recent work in the legal academy also shows how intra-firm activity can
result in suboptimal capital structures for a given collection of assets. As
the story goes, the precise location of a firm’s borders at any point in time
will be the result of a mindful balancing between these competing effects.
Yet this account has always been somewhat misleading: there is space
between markets and hierarchies. Business alliances, joint ventures,
franchise agreements, and other structures offer firms a middle path
between market exchange and unconditional firm control. Furthermore, the
recent rise in business outsourcing transactions presents another intriguing
context for studying hybrid organizational structures. Under many of these
arrangements, assets (both physical and intangible) are legally owned by
an offshore vendor, but the use of these assets is subject to partial control
rights retained by the operational client.
This article explores the growth of business outsourcing, how it works,
and why two firms might logically enter into an outsourcing arrangement
*
Associate Professor, The University of Alabama School of Law; Visiting Associate
Professor, The University of Virginia School of Law, 2007-08; Visiting Professor, The
Indian School of Business, Hyderabad, India. E-mail: ggeis@law.ua.edu. Thanks to
Margaret Blair, Albert Choi, Jody Kraus, Jennifer Hill, Rich Hynes, Paul Mahoney, Greg
Mitchell, Erin O’Hara, Mark Ramseyer, Barak Richman, Randall Thomas, and George
Triantis for helpful conversations and comments on this topic. An earlier version of this
paper was presented at the 2007 International Corporate Governance Conference at
Vanderbilt University Law School and benefited from feedback at that event.
2
George S. Geis
[15-Feb-08
not only to cut production costs—but also to craft a sensible governance
compromise. It also asks, more generally, whether increased diversity of
organizational structures is starting to provide firms with a richer menu of
strategies for sharing operational risk—in the same way that recent
innovations in corporate finance and capital markets are dramatically
altering ownership strategies on the right side of the balance sheet.
INTRODUCTION ........................................................................................................2
I. CONCEPTUALIZING THE FIRM.......................................................................8
A. TRANSACTION COST THEORIES .............................................................................9
B. AGENCY COST THEORIES .....................................................................................11
C. CAPITAL STRUCTURE THEORIES ..........................................................................15
1.
The Link Between Asset Characteristics and Capital Structure..............15
2.
Intra-Firm Barriers to Capital Structure Granularity ............................18
D. HYBRID ORGANIZATIONAL ENTITIES ...................................................................21
II. THE OUTSOURCING REVOLUTION .............................................................25
A. DISTINGUISHING THE OFFSHORING AND OUTSOURCING DECISIONS ....................26
B. THE LEGAL STRUCTURE OF OUTSOURCING..........................................................28
C. OUTSOURCING AS A GOVERNANCE COMPROMISE ................................................30
1.
Seeking Market Discipline for Input Prices ............................................31
2.
Mitigating the Hold-Up Problem from Specialized Investment ..............32
3.
Narrowing the Scope of Agency Distortions ...........................................33
4.
Fine Tuning Capital Structure to Asset Clusters.....................................34
5.
A Summary Example ...............................................................................35
III. DECONSTRUCTING OPERATIONAL ACTIVITY......................................37
A. THE SYNDICATION EXPERIMENT IN FINANCE ......................................................38
B. WAS ENRON RIGHT?............................................................................................41
C. IMPLICATIONS OF MORE COMPLETE OPERATIONAL STRUCTURES .......................44
IV. EMPIRICALLY ASSESSING OUTSOURCING .............................................47
CONCLUSION...........................................................................................................49
INTRODUCTION
Relocating economic production is nothing new, and companies have
continually sought to move business activity to areas with cheaper labor
markets as transportation costs drop. Yet over the past decade there has
been a notable increase in the willingness of firms to cast their supply
chains beyond the boundaries of the United States.1 For manufacturing
1
It is worth noting that these developments can have significant macroeconomic
repercussions: moving economic activity beyond domestic borders raises important
15-Feb-08]
The Space Between Markets and Hierarchies
3
firms, passage of the North American Free Trade Agreement in 1994
represented a major milestone. High-profile companies quickly shifted
portions of their work to Mexican “maquilodoras,” the labor-intensive
assembly operations located just over the border.2 And China has emerged,
of course, as manufacturing breadbasket to the world through its taxadvantaged economic zones and shockingly low labor rates.3
On the services side of the economy, an estimated 4.1 million jobs will
have moved, as of 2008, from developed economies to places like India,
Vietnam, Brazil, and the Philippines.4 India, in particular, has attracted
notice for its rapid growth in information technology and other
sophisticated outsourcing services—including financial analysis, medical
imaging, and drug discovery.5 And this may represent just the tip of the
iceberg: according to one estimate, nearly 160 million jobs in the service
economy, about 11 percent of total employment in developed countries,
could theoretically be performed anywhere in the world.6 Nobody expects
this many positions to move overseas, but analysts do project the size of the
total offshoring market to continue its extraordinary ascent.7
concerns related to the social implications of change. This paper does not take on these
difficult issues, however, and concentrates exclusively on the microeconomic, firm-level
decisions related to offshoring.
2
During the first five years after the passage of NAFTA, maquila employment grew
by an estimated 86 percent. Richard H.K. Vietor & Alexander Veytsman, American
Outsourcing, HARV. BUS. SCHOOL Publishing No. 9-705-037, at 3-6 (2005). Similarly,
the number of maquila plants ballooned from roughly 2700 in 1997 to 3700 in 2001. Id.
3
Id. at 7-9.
4
McKinsey Global Institute, The Emerging Global Labor Market: Part 1—The
Demand for Offshore Talent in Services, at 23-25 (2005), available at
http://www.mckinsey.com/mgi/publications/emerginggloballabormarket/index.asp.
5
See, e.g., The Next Wave: India’s IT and Remote-Service Industries Just Keep on
Growing, THE ECONOMIST, Dec. 14, 2005. According to India’s National Association of
Software and Service Companies (NASSCOM), technology and outsourcing services
revenue has increased by nearly a third (to almost $40 billion) for the fiscal year ending in
March, 2007. Pui-Wing Tam & Jackie Range, Some in Silicon Valley Begin to Sour on
India, WALL ST. J., A1 (July 3, 2007).
6
See McKinsey Global Institute, supra note 4, at 22. McKinsey estimates this figure
by examining business activity in eight industry sectors and extrapolating these results to
the entire services economy. Id. at 22-23. The report does not suggest, however, that the
actual number of jobs outsourced will come anywhere close to 160 million, citing a wide
variety of industrial, organizational, regulatory, and social factors that will significantly
limit this number. Id. at 25-28.
7
See, e.g., National Association of Software and Service Companies, Strategic Review
2007
(2007),
available
at
http://www.nasscom.in/Nasscom/templates/NormalPage.aspx?id=50856 (estimating a
strong liklihood that offshored services will reach $60 billion by 2010); The Gartner
Group, Gartner on Outsourcing: 2005 (2005) (projecting rapid growth in outsourcing). A
large collection of reports and statistics related to the growth of offshore outsourcing can
4
George S. Geis
[15-Feb-08
What, then, is causing firms to embrace global supply chains? Why are
they increasingly turning to foreign production as a strategy for bringing
goods and services to market? The conventional answer is that offshoring is
just part of a never-ending quest for lower production costs via labor
arbitrage. And indeed, the economics of change can be compelling when
improved communication and transportation networks open new
opportunities to hire workers for one-tenth the price of those in more
developed countries.
But there is more to this story. Firms are also starting to pursue some
intriguing contractual approaches—where assets are legally owned by an
offshore vendor, but the use of these assets is subject to partial control
rights retained by the onshore client.8 Under these hybrid arrangements,
each firm accepts some operational risks (presumably those which they can
best manage through economies of scale, diversification, or other means),
while other risks are shed to a counterparty. Likewise, complex outsourcing
deals can involve intermediate levels of capital investment, commitment,
and reward.
In this article I will advance two claims—one theoretical, and the other
exploratory. First, I will make a theoretical argument that offshore
outsourcing (along with other hybrid structures) can serve as a sensible
governance compromise between the traditional extremes of markets and
hierarchies.9 This is true for four general reasons. First, it allows firms to
also be found at http://www.rttsweb.com/outsourcing/statistics/. The prognosis for
outsourcing is not inevitiably positive, however, especially as wages continue to rise in
some parts of India. See Tam & Range, supra note 5 (reporting on a reversal of IT
offshoring in some parts of Silicon Valley); Deloitte Consulting, Calling a Change in the
Outsourcing Market: The Realities for the World’s Largest Organizations (2005),
available
at
http://www.deloitte.com/dtt/cda/doc/content/us_outsourcing_callingachange.pdf (warning
that outsourcing is not working for many firms and that growth is likely to wane).
8
There is nothing particularly special, of course, about the international component of
these transactions—they could occur just as easily in Houston as in Hyderabad (and
undoubtedly do). Yet the vanguard of this trend seems to be mustering overseas, and I will
focus much of the discussion here.
9
The foundational literature on markets versus hierarchies is discussed infra Part I.A.
The possibility of hybrid compromise has been raised elsewhere, of course—primarily in
the management literature on business alliances and in the economic and marketing
literature on “make-or-buy” sourcing decisions. See, e.g., R.J. David & S.K. Han, A
Systematic Assessment of the Empirical Support for Transaction Cost Economics, 25
STRAT. MGMT. J. 39 (2004) (reviewing management work in this area); Aric
Reindfleisch & Jan B. Heide, Transaction Cost Analysis: Past Present and Future
Applications, 61 J. MKTG. 30 (1997) (reviewing marketing work in this area). I discuss
some of the problem areas in this literature infra Part I.D. Moreover, recent insights linking
the borders of a firm to legal considerations impacting capital structure makes it
worthwhile to reconsider the theoretical benefits of hybrid organizational entities under this
15-Feb-08]
The Space Between Markets and Hierarchies
5
reintroduce some of the market pressure on input prices that is lost with
exclusive corporate ownership. Second, hybrid outsourcing can guard
against some of the hold-up concerns plaguing relation-specific investment
in pure market transactions—by carving out control rights in enumerated
areas. Third, it can reduce the agency cost distortions that arise when an
investor’s assets are controlled by firm managers. And finally, it can
facilitate more granular capital structures, where financing incentives are
better matched to the underlying characteristics of asset clusters. Of course
there are tradeoffs here, and more traditional approaches to economic
organization also have their place.
The second goal of this paper is to raise the possibility that we are
moving toward an increasingly complete array of operational alternatives—
as falling transaction costs press organizational contracting to its theoretical
limits. Indeed, emerging developments in this area might be seen as an
operational parallel to the current revolution in corporate finance—which is
providing firms with a wider array of funding alternatives through the use
of derivatives, insurance, syndication, and other innovations.10 In a nutshell,
I ponder whether this sort of transformation—from discrete to continuous
options for slicing ownership, control, commitment, and risk—may be
taking place on the left side of the balance sheet as well as on the right.
An example might help to illustrate the organizational importance of
business outsourcing. Consider a strategic dilemma faced by Wachovia
Bank near the end of 2005. The North Carolina firm had grown rapidly into
one of America’s major financial institutions, largely through a strategy of
acquiring rivals.11 Yet it had long resisted any attempt to cut operating costs
paradigm. See, e.g., Edward M. Iacobucci & George G. Triantis, Economic and Legal
Boundaries of the Firm, 93 VA. L. REV. 515, 564 (2007) (raising the possibility that
intermediate organizational structures might be efficient compromises in light of a capital
structure theory of the firm).
10
Recent work in the legal academy has considered the effect of these innovations
(combined with improvements in risk management), especially in relation to the use of
private-equity backed leveraged buyouts or other strategies for recapitalizing or securing
new capital. See, e.g., Ronald J. Gilson & Charles K. Whitehead, Deconstructing Equity:
Public Ownership, Agency Costs, and Complete Capital Markets, 107 COLUM. L. REV.
(forthcoming 2007), available at http://ssrn.com/abstract=991352 (discussing the
development of complete capital markets and arguing that diversified equity holders may
not always constitute the cheapest source of capital); Henry T.C. Hu & Bernard S. Black,
The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, 79 S. CAL. L.
REV. 811 (2006) (exploring the use of derivative instruments to separate voting rights from
equity ownership); Henry T.C. Hu & Bernard S. Black, Equity and Debt Decoupling and
Empty Voting II: Importance and Extensions, 156 U. PA. L. REV. 625 (forthcoming 2008)
(extending their earlier work); Frank Partnoy & David A. Skeel, Jr., The Promise and Peril
of Credit Derivatives, 75 U. CIN. L. REV. 1019 (2007) (describing the rise of new
financial products allowing credit holders to share risk).
11
See, e.g., A Golden Handshake, THE ECONOMIST, May 9, 2006 (online only);
6
George S. Geis
[15-Feb-08
by moving its banking activity overseas.12 Eventually, however, Wachovia
awoke to the dawning realization that it was lagging behind competitors,
and the firm decided to send part of its back office work to India.13
The conventional way to structure this sort of project, at least in the
financial services industry, was to establish a captive international business
that would serve, in effect, as a legally-owned division of Wachovia. This is
exactly how most other banks had made their passage to India.14 Yet
Wachovia recognized that this sort of strategy was unlikely to net it the
cheapest cost structure. Among other things, the firm enjoyed no brand
recognition in India and would need to pay relatively higher salaries to
attract suitable workers away from firms like Infosys, Wipro, or
Cognizant.15 More generally, a captive structure would shelter ongoing
work from competitive market pressures in a way that independent
relationships would not. Further, it would expose Wachovia’s investors to
incremental abuses, as managers in far-removed Bangalore might use
private information to line their pockets, lighten their workload, or assume
unwarranted risks.16
Wachovia also considered a second organizational strategy: putting its
projects up for bid among a dozen or so prominent outsourcing vendors.
Indeed, this is exactly what it did for some work in information technology
and human resources.17 Yet the bank was reluctant to follow this path for
especially sensitive parts of the value chain; jettisoning the work completely
might sever Wachovia’s control over its back-office operations and expose
the firm to new risks related to customer privacy, intellectual property
leakage, or other breakdowns. And it would be more dangerous to invest
heavily in connecting domestic operations to these back office centers
because the vendor might seek to extort higher prices later during
renegotiations.
Wachovia ultimately struck a hybrid deal with a firm named Genpact—
With Open ARMs, THE ECONOMIST, May 11, 2006 (describing Wachovia’s acquisition
strategy).
12
See Dean Foust, Wachovia’s Change of Heart, BUSINESS WEEK ONLINE, Jan.
30,
2006,
available
at
http://www.businessweek.com/magazine/content/06_05/b3969422.htm.
13
Id.
14
Id.
15
Id.
16
More subtly, there was conceivably a capital structure mismatch between the overall
financing of Wachovia (which would presumably be used to fund a captive venture) and
the optimal capital structure for the Indian assets. See infra Part III.D.
17
The information technology work was awarded to Infosys Technologies and
Cognizant Technologies; the human resources work was outsourced to Hewitt Associates.
Foust, supra note 13.
15-Feb-08]
The Space Between Markets and Hierarchies
7
an outsourcing vendor recently spun-off from General Electric.18 The
parties agreed that Genpact would take legal ownership of the real estate,
computer servers, human capital, and other assets needed to perform
Wachovia’s back office services. But, importantly, Wachovia carved out
broad areas of control related to the manner in which this work would be
conducted. The bank retained the power, for example, to hire and fire key
managers running this division, and to set procedures for critical
operations.19 It also received a dedicated building with a security system
barring other Genpact employees from using these facilities.20 And it
insisted on a long-term contract.21 Technically, this sort of arrangement still
falls outside the legal boundaries of a firm. Practically, however, it falls
somewhere in between a spot transaction and captive ownership. This paper
argues that these hybrid structures can sometimes serve as a sensible
governance compromise when a firm decides where to erect its borders.
The discussion is organized as follows. Part I sets the stage by briefly
reviewing foundational work conceptualizing the firm—including recent
research showing how capital structure design relates to the location of a
firm’s legal borders. It continues by discussing the historical study of hybrid
organizational forms, concluding that the product of this work has been
somewhat disappointing. Part II turns to the rise of business outsourcing
and the theoretical benefits of using complex contracting to finesse
governance tensions underlying intra-firm activity. Part III explores how
future developments along this trend line might lead to an increasingly
complete array of organizational options—and by offering some
preliminary thoughts about what greater use of this space between markets
and hierarchies would mean for the management and legal apportionment of
economic activity. Part IV [currently in progress] finishes by discussing the
18
See If in Doubt, Farm it Out, in NOW FOR THE HARD PART: A SURVEY OF
BUSINESS IN INDIA, THE ECONOMIST, June 3, 2006, at 6. The Genpact story also
presents interesting considerations related to the theory of the firm. Established as an early
provider of offshore services in India to General Electric, Genpact was spun off from that
firm in 2005 to unlock new growth opportunities. See. e.g., Moumita Bakshi Chatterjee,
Genpact Eyes Buy in US, UK, HINDU BUS. LINE, Jan. 11, 2008. Genpact went public in
2007 on the New York Stock Exchange under the coveted symbol “G.” Steve Gelsi,
Genpact Marks Fourth-Richest IPO of the Summer, MarketWatch, Aug. 2, 2007, available
at
http://www.marketwatch.com/news/story/genpact-marks-fourth-richestipo/story.aspx?guid=%7BE3071DE0%2D3774%2D4442%2DBF0E%2D25315BD44BD8
%7D.
19
Id. Author’s confidential interview with Genpact executive dated Dec. 27, 2006.
20
Author’s confidential interview with Genpact executive dated Dec. 27, 2006.
21
The initial contract ran for seven years. Press Release, Wachovia and Genpact
Announce
Outsourcing
Agreement
(Dec.
2,
2005),
available
at
http://www.sharedxpertise.com/file.php?wsb=3046/wachovia-and-genpact-announceoutsourcing-agreement.html.
8
George S. Geis
[15-Feb-08
role that empirical analysis should play in determining whether this
governance feature of outsourcing really matters. A brief conclusion
summarizes the article.
I. CONCEPTUALIZING THE FIRM
Despite the complexity surrounding many modern corporations, it is
still possible to envision any firm as a basic collection of inputs and outputs.
Every company, from those selling shoes and staplers to those designing
drugs and derivatives, accepts capital inputs from investors and uses this
cash to purchase physical or intangible assets (including labor). These assets
are then deployed against a business model in the pursuit of incremental
value. The profits (in good times) or the shortfalls (in bad) are ultimately
absorbed by the firm or accrue to investors. The yin and yang of these
financing and operating decisions are reflected, of course, in a firm’s
financial statements: debt and equity investments are tallied on the right
side of the balance sheet, while operational uses of this money appear on
the left.22
Yet this basic accounting framework tells us little about how a firm’s
owners, directors, and managers determine the size of their organization.
What are the advantages of stuffing cash and assets into a corporate
behemoth? What are the drawbacks? Is it better to operate as a nimble firm
by stitching together a virtual value chain with only the thinnest veneer of
corporate ownership? The optimal strategy is hardly obvious; even in the
same industry, dwarves often compete with giants. Therefore, in order to set
the stage for the rest of the paper, it is necessary to briefly review three
different approaches for conceptualizing a firm: transaction cost theories,
agency cost theories, and capital structure theories.23
22
This is true, of course, primarily for longer-term changes to operations. Information
on a firm’s short-term operating activities is typically reflected in other financial
statements. Moreover, financial reporting does not necessarily reflect a firm’s full
economic position, as some assets or liabilities may be kept “off balance sheet.”
23
These three approaches have been quite influential in the economic and legal
scholarship, but it is important to note that they are not the only ways to understand the
benefits of operating within a firm. For instance, recent scholarship has explained the rise
of the corporate entity as a legal mechanism that allows joint owners (shareholders) to
“lock-in” or commit assets to a venture without facing a risk that their co-owners will
behave opportunistically. See Margaret M. Blair & Lynn A. Stout, A Team Production
Theory of Corporate Law, 85 VA. L. REV. 247 (1999); Margaret M. Blair, Locking In
Capital: What Corporate Law Achieved for Business Organizers in the Nineteenth Century,
51 UCLA L. REV. 387 (2003).
15-Feb-08]
The Space Between Markets and Hierarchies
9
A. Transaction Cost Theories
Imagine, as a useful starting exercise, that a new firm has a large pot of
cash sitting on the boardroom table—along with a foolproof business plan.
It must now decide the best way to secure the various inputs needed to
transform raw materials (broadly defined) into higher value outputs. Should
it purchase and own these assets under the firm’s capacity as a legal person?
Or should it strike arm’s length contracts on the open market for the
necessary goods and services?
This fundamental choice about the best way to legally compartmentalize
asset ownership is the jumping off point for transaction cost theories of the
firm. Ronald Coase’s seminal paper on the topic framed the inquiry by
asserting that external contracts should trump firm ownership—at least in
an idealized world with competitive markets and zero transaction costs.24
This is true because sourcing any given activity internally shields
production from the pressures of the marketplace; the constant threat of
losing a sale to competitors is absent. But commercial exchange is not
frictionless, of course, and Coase hypothesized that firms may sensibly
incur slightly higher production costs in order to avoid the “transaction
costs of contracting.”25
He was a little unclear, however, on the exact nature of these transaction
costs, and much of the work in this area seeks to flesh out a more
compelling narrative. The literature here is vast, and I will only sketch a few
highlights.26 First, an obvious category of transaction costs arises with the
need to negotiate and memorialize the terms of any agreement: purchasing
managers and corporate attorneys demand payment for their efforts. Yet this
explanation is not entirely satisfying—because administrative costs must
also be incurred with internal firm production, as managers work to
negotiate transfer pricing formulas and harmonize production schedules.
24
See R.H. Coase, The Nature of the Firm, 4 ECONOMICA 389 (1937).
Id. at 390.
26
For a helpful review of scholarship in this area through 1999, see Nicolai J. Foss et
al., The Theory of the Firm, in 1 ENCYCLOPEDIA OF LAW AND ECONOMICS 631
(Boudewijn Bouckaert & Gerrit De Geest eds., 2000). Oliver Williamson has significantly
expanded upon Coase’s initial insight by discussing the importance of bundling
relationship-specific assets into a firm to avoid counterparty opportunism, and, more
generally, by showing how a proper conception of transaction costs should include both the
direct costs of managing relationships and the opportunity costs of suboptimal governance
decisions. See OLIVER E. WILILAMSON, MARKETS AND HIERARCHIES (1975);
OLIVER E. WILILAMSON, THE ECONOMIC INSTITUTIONS OF CAPITALISM:
FIRMS, MARKETS, AND RELATIONAL CONTRACTING (1985) [hereinafter,
ECONOMIC INSTITUTIONS]; OLIVER E. WILILAMSON, THE MECHANISMS OF
GOVERNANCE (1996).
25
10
George S. Geis
[15-Feb-08
Anyone who has tried to navigate the shoals of a large corporate
bureaucracy is familiar with these hazards. Thus, it is hardly self-evident
that the costs of external negotiation are worse than the politics of internal
coordination—though the relative difference in these burdens could still
provide a plausible rationale for the location of some economic activity.
A second, and more nuanced, understanding of contractual transaction
costs involves relation-specific investments. The general idea here is that
some assets can be fairly understood to have a high value for one firm—
typically because that user can combine the good with other specialized
inputs—while the same assets are worth less to everyone else.27 A maker of
aluminum cans, for example, might wish to source molten aluminum from
the neighboring smelter to minimize transportation costs and generate other
efficiencies.28 Other users may derive less benefit from geographic
proximity. The problem, of course, is that the smelter may demand higher
prices from the can maker—after construction of the can plant is finished—
in order to expropriate some of the value from this relation-specific
investment. And recognizing this risk, firms may even decide to forgo
fruitful investments—by replacing uniquely tailored assets with more
general ones.29
One obvious way to mitigate this “hold-up” problem is simply to write a
long-term supply contract at a fixed (or indexed) price. Indeed, protecting
relation-specific investments is commonly touted as a fundamental
justification for legally empowering parties to bind themselves via
contract.30 Yet unforeseen or remote contingencies may prevent a party
from anticipating, and securing contractual protection against, every variety
of opportunistic renegotiation. As the familiar refrain goes, it is impossible
to document all conceivable future states of the world, and low-probability
events may resurrect the hold-up problem when parties fail to plan for these
contingencies.31 In short, the ever-present risk that contractual
27
See WILILAMSON, supra note 26.
For instance, the can maker might be able to avoid constructing an ingot re-melting
facility by transporting liquid aluminum (which hardens after a short period of time)
directly to its manufacturing molds. See, e.g., VICTOR GOLDBERG, FRAMING
CONTRACT LAW 350-51 (2006) (describing litigation involving a contractual relationship
along these lines). Other users of hardened aluminum may not enjoy such a benefit.
29
Continuing the example, the can manufacturer may just decide to build the
aluminum re-melting facilities after all, even though this would lead to less efficient
operations.
30
See, e.g., Alan Schwartz & Robert E. Scott, Contract Theory and the Limits of
Contract Law, 113 YALE L.J. 541, 559–62 (2003) (describing the important role of contract
law in enabling parties to make relation-specific investments).
31
See, e.g., ROBERT COOTER & THOMAS ULEN, LAW AND ECONOMICS 21117 (4th ed. 2004); STEVEN SHAVELL, FOUNDATIONS OF ECONOMIC ANALYSIS OF
LAW chs. 13-16 (2004); Oliver Hart & John Moore, Incomplete Contracts and
28
15-Feb-08]
The Space Between Markets and Hierarchies
11
counterparties will find some way to suck all the value out of relationspecific investments magnifies the bite of market exchange.
The alternative solution, of course, is simply to vertically integrate
complimentary assets into one legal organization. There is no need to worry
about obscure contractual contingencies when can maker owns smelter.
Firms can simply reserve decisions about how these assets will be deployed
over time and retain the managerial hierarchy needed to eke out all future
benefits from complementarity. More robust theories have been built upon
this theoretical cornerstone—such as the “property rights” theory of
economic organization,32 or frameworks exploring the use of specialized
human capital within a firm.33 Yet all of this work shares the common
insight that aggregating production into one legal entity can protect against
the hold-up problem inherent with relation-specific assets. The optimal
location of a firm’s borders, then, is thought to be the result of balancing
these benefits against the greater production costs that must be incurred
when the activity is shielded from direct market pressure.34
Unfortunately, however, there is another downside to centralizing
economic activity within a firm: those empowered to make corporate
decisions may have incentives to take selfish actions that harm residual
owners. The next section focuses on these agency distortions and considers
how they relate to firm governance.
B. Agency Cost Theories
The agency cost problem is fundamentally a bad news story—all clouds,
with no silver lining. The heart of the dilemma comes from a simple truth: it
is expensive (and ultimately impossible) to prevent parties from taking selfinterested actions when they are given control over other people’s money.35
Renegotiation, 56 ECONOMETRICA 755 (1988); Schwartz & Scott, supra note 30, at
594-95.
32
See Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A
Theory of Vertical and Lateral Integration, 94 J. POL. ECON. 691 (1986); Oliver D. Hart
& John Moore, Property Rights and the Nature of the Firm, 98 J. POL. ECON. 1119
(1990) (developing a property rights theory of economic organization).
33
Raghuram G. Rajan & Luigi Zingales, Power in a Theory of the Firm, 113 Q. J.
ECON. 387 (1998) (extending this theory to include intangible assets, such as human
capital).
34
It is important to note that a robust collection of empirical work seeks to test these
theories by linking an industry’s dependence on specialized assets to the organizational
structures observed within that industry. I discuss the basic goals, successes, and limits of
this work infra Part I.D.
35
The agency cost problem has been discussed extensively in the legal and economic
literature. The foundation for much of this work can be found in ADOLPHE BERLE &
GARDINER MEANS, THE MODERN CORPORATION AND PRIVATE PROPERTY
12
George S. Geis
[15-Feb-08
These distortions arise through information asymmetries between the
principal and agent.36 In other words, if a principal could freely observe and
understand how an agent’s actions impacted her wealth, then the agent
would have no reason to behave differently than the principal would—when
faced with the same circumstances. But a principal cannot read the mind of
her agent, of course, and it is often difficult to know whether bad (or good)
outcomes are caused by acts of the agent or by external factors beyond
everyone’s influence.37
Concealed by this cloud of uncertainty, an agent may engage in a
variety of undesirable actions—in essence, running up an expensive (and
hidden) tab that is ultimately sent to the principal’s table. The agent may,
for instance, spend time on easy tasks instead of taking on difficult, but
more-important, ones.38 He may stuff his pockets with hidden compensation
and other perks.39 Or he may make decisions that are personally optimal—
but counter to those that a fully-informed principal would prefer.40 A
principal will generally be aware of these distorted incentives, of course,
and may invest in monitoring activities to guard against malfeasance. Yet
monitoring is itself costly and unlikely to prevent every abuse; furthermore,
a proper tally of agency costs must also include these incremental outlays.41
(1932); and Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial
Behavior, Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976). For
additional background on agency theory, see Kenneth J. Arrow, The Economics of Agency,
in PRINCIPALS AND AGENTS: THE STRUCTURE OF BUSINESS 37 (John W. Pratt
& Richard J. Zeckhauser eds., 1985); Kathleen M. Eisenhardt, Agency Theory: An
Assessment and Review, 14 ACAD. MGMT. REV. 57 (1989); Eugene F. Fama, Agency
Problems and the Theory of the Firm, 88 J. POL. ECON. 288 (1980); Sanford J. Grossman
& Oliver D. Hart, An Analysis of the Principal-Agent Problem, 51 ECONOMETRICA 7
(1983).
36
These asymmetries are sometimes divided between the “hidden action” and the
“hidden information” of an agent. See, e.g., Arrow, supra note 35.
37
Jensen & Meckling, supra note 35.
38
See, e.g., JEAN TIROLE, THE THEORY OF CORPORATE FINANCE 16 (2006)
(describing this sort of suboptimal task allocation, rather than insufficient work hours or
time wasted on YouTube, as the primary manifestation of shirking).
39
Id. at 17.
40
These inefficient decision typically stem from a mismatch between the risk profiles
of agent and principal. For example, an agent may take too little risk with his principal’s
property by making overly-safe decisions that preserve the agent’s job. Alternatively, he
may take on too much risk by “gambling for resurrection” in hard times. Id. at 16-17. See
also Barry E. Adler, A Re-examination of Near-Bankruptcy Investment Incentives, 62 U.
CHI. L. REV. 575, 576 (1995) (arguing that managers “have a strong incentive to gamble
with the firm’s assets” in times of financial distress).
41
See Jensen & Meckling, supra note 35, at 308 (defining agency costs as the sum of
the principal’s monitoring costs, the agent’s bonding costs, and the residual loss measured
as the “dollar equivalent of the reduction in welfare experienced by the principal” as a
result of divergent agent interests).
15-Feb-08]
The Space Between Markets and Hierarchies
13
In the context of a firm, the typical focus for agency problems centers
on the relationship between investor and manager. The shareholders, as
capital contributors and residual owners, are viewed as principals, and the
managers, enjoying discretion over most decisions, are seen as agents.42
Importing the agency framework in this manner is a bit artificial—there
may be other parties, such as debt investors or trade creditors, who also
maintain an ownership stake (though generally not a residual one, unless the
firm becomes financially distressed).43 Nevertheless, agency theories do
seem to have some explanatory and predictive power over the inner
workings and governance of a corporation.44
Viewed in this manner, agency costs offer another reason to avoid
centralizing economic activity within a firm. Large and complicated
corporations harbor plenty of dark corners, and managers have incentives to
use this information asymmetry to take advantage of equity owners. These
problems are compounded when economic ownership of corporate assets is
split among a diffuse population of shareholders—who may find it difficult
to coordinate monitoring defenses.45 By contrast, agency costs can
conceivably be reduced if the same assets are divided into many discrete
firms, each run by an owner-manager.46 Any comprehensive accounting of
the costs and benefits of consolidated firm activity must therefore include
the drag of agency distortions. In short, these undesirable incentives act as a
toll on the centralization of economic activity and, all else being equal, tilt
production towards the use of market transactions.47
Because the agency cost problem is thought to be especially acute
between shareholders and managers, one strategy for mitigating these
distortions might be to tinker with a firm’s capital structure. Or, said
differently, pressing the agency cost theory of the firm to its logical
42
Id.
See, e.g., Douglas G. Baird & Robert K Rasmussen, Private Debt and the Missing
Lever of Corporate Governance, 154 U. PA. L. REV. 1209 (2006) (focusing on the
ownership and governance role of debt investors).
44
For example, the range of governance topics discussed under the rubric of agency
theory includes hostile takeovers, proxy fights, share blockholding, independent directors,
disclosure requirements, and so on. See TIROLE, supra note 40.
45
See, e.g., Bernard S. Black, Shareholder Passivity Reexamined, 89 MICH. L. REV.
520 (1990); Edward B. Rock, The Logic (and Uncertain) Significance of Institutional
Shareholder Activism, 79 GEO. L.J. 445 (1991).
46
It is worth noting that the agency cost problem does not disappear when firm activity
is replaced by a long term contract: a promisor-agent may still take actions that are
inconsistent with the desires of a promisee-principal. See Jensen & Meckling, supra note
35. But the narrower scope of discretion, along with the reduced complexity of operational
activity, may cut the magnitude of agency risk.
47
Though it is again worth emphasizing that contractual transactions may also suffer
from agency distortions.
43
14
George S. Geis
[15-Feb-08
conclusion suggests that the use of public equity may ultimately be inferior
to other financing structures that avoid such a wide gulf between managerial
incentives and residual owner payoffs. Michael Jensen famously predicted
as much in the 1980’s, arguing that “the publicly held corporation … has
outlived its usefulness in many sectors of the economy and is being
eclipsed” by the use of public and private debt.48 This provocative statement
was somewhat ahead of its time, but recent recapitalizations have indeed
turned to more leveraged capital structures—typically via private equity
buyouts—in order to replace the agency costs of public equity with
contractual debt.49 These new financing structures are not perfect—and they
can mutate into additional strains of the agency cost problem50—but the
general notion of substituting debt for public equity to cut agency costs
maintains some appeal.
But no matter where firms obtain their capital, they do not create value
by sitting on large piles of cash like Scrooge McDuck. It is what they
choose to do with this capital, typically in combination with labor inputs,
that generates incremental wealth. In other words, the operating decision
cannot be fully divorced from the financing decision—they are two sides of
the same coin (or, more accurately, the same T account). Recent work in the
legal academy has seized on the importance of this holistic approach to
argue that the borders of a firm might logically be related to an efficient
match between various operating assets and the underlying capital that
funds these assets. Let me turn now to discuss this capital structure theory
of the firm.
48
Michael C. Jensen, Eclipse of the Public Corporation, HARV. BUS. REV. 61
(Sept.-Oct.
1989)
(revised
1997),
available
at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=146149.
49
Lenders will still suffer from the agency cost problem, of course, because managers
enjoy control over many decisions that affect the borrowed funds (and thus the ability to
repay). See Jensen & Meckling, supra note 35. Yet lenders are theoretically exposed to a
narrower slice of agency risk because they can use contractual provisions (such as line-ofbusiness covenants or financial ratio requirements) to mitigate the scope of distortions.
Ongoing contractual obligations to repay debt (whether through amortized payment
schedules, or, more starkly, through sinking fund provisions) can also act to muffle agency
risk.
50
Michael Jensen, for example, has famously reversed course—arguing that the
economic structure of private equity investing has mutated into a different sort of agency
monster that suffers from new distortions caused by principal-investors handing over their
money to agent-fund managers. In essence, the distortions are pushed up one level, as
private equity partners use special dividends, consulting fees, deal-completion
commissions, and other dubious practices to extract private rents. Indeed, Jensen has
predicted that there will soon be a high-level scandal in the private equity industry,
equivalent to the Enron fiasco. See, e.g., Gretchen Morgenson, It’s Just a Matter of Equity,
N.Y. TIMES C1, Sept. 16, 2007.
15-Feb-08]
The Space Between Markets and Hierarchies
15
C. Capital Structure Theories
1. The Link Between Asset Characteristics and Capital Structure
Historically, the biggest financing decision facing a firm has been
whether to line its coffers with debt or equity. Issuing debt allows the firm
to raise money without sacrificing residual control rights.51 The price of this
discretion is an ironclad repayment schedule, fixed in contract law, and
perhaps a security interest in some of the firm’s assets. Issuing equity, on
the other hand, offers greater flexibility on the repayment terms; managers
are free to stash all of the proceeds within the firm for years before
returning profits to equity investors through dividends or share buybacks.
The tradeoff, of course, is that shareholders become residual owners of the
firm and will earn a say in major operating decisions.52 And despite the
Nobel Prize-winning theories on capital structure irrelevance,53 firms pay
serious attention to the optimal balance between debt and equity.54
In fact, any comprehensive understanding of a firm’s capital structure
needs to go beyond the initial weighting of debt versus equity. Corporate
finance scholars are not only concerned with the ideal amount of leverage;
51
Of course creditors will typically negotiate for contractual covenants placing some
boundaries on managerial discretion—either by affirmatively mandating some activities
(such as financial reporting) or negatively prohibiting other ones (such as investing the
money outside current lines of business). In good times these covenants may not matter
much. But they can pose more meaningful implications for corporate governance if a firm
starts to falter. See Baird & Rasmussen, supra note 43 (examining the role of creditors and
elaborate financial covenants in corporate governance decisions).
52
Most day-to-day decisions are delegated, of course, to managers and directors—
leaving shareholders with a direct vote on only a few extraordinary matters. For this reason,
the practical extent of shareholder control comes mostly via representation.
53
See Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation
Finance, and the Theory of Investment, 3 AM. ECON. REV. 261 (1958) (setting out two of
their famous and provocative propositions that a firm’s capital structure will not generate
incremental value—under certain, stylized assumptions); Peter H. Huang & Michael S.
Knoll, Corporate Finance, Corporate Law and Finance Theory, 74 S. CAL. L. REV. 175
(2000) (arguing that the real benefits of the M&M theorem for corporate law scholars come
from relaxing its simplifying assumptions one by one).
54
See, e.g., HOWELL E. JACKSON ET AL., ANALYTICAL METHODS FOR
LAWYERS 232 (2003) (“[S]ubsequent writers (including Modigliani and Miller
themselves) have argued … that the choice of capital structure makes a difference in firm
value because the simplifying assumptions in the original article are not true in reality.”).
The decision is also complicated by the availability of intermediate instruments, such as
preferred stock or convertible debt, to parcel out control and cash-flow rights in a more
nuanced manner. See, e.g., Alexander J. Triantis & George G. Triantis, Conversion Rights
and the Design of Financial Contracts, 72 WASH. U. L.Q. 1231 (1994) (describing some
intermediate financing alternatives). Yet a rigid dichotomy has always remained—at least
in the eyes of the law—between contractual debt and residual equity.
16
George S. Geis
[15-Feb-08
they also study the contractual strings that come attached to this money—
strings like business line covenants, conversion rights, cross-default clauses,
and repayment provisions.55 Similarly, a full understanding of the terms
underlying any equity investment should include governance provisions
such as director voting rules, class preferences, and anti-takeover defenses.
In this manner, capital structure theory might be better viewed as an
exercise in optimal contract design.56
How, then, should a firm elect to raise its money? The answer is quite
complicated, but it is worth noting at the outset that firms don’t simply
pursue investors as a form of sport: they need funds in order to pay for the
projects used to transform raw materials into higher value outputs. In other
words, checks written by the COO must be paid for by the CFO. And,
importantly, the determinants of an efficient capital structure will often
depend on the nature of these assets (along with a host of other
considerations, such as current economic conditions and tax, corporate,
bankruptcy, and securities laws). The optimal capital structure may
therefore vary by industry. To be sure, any group of assets can conceivably
be financed with any sort of investment—but, like drinking a heavy
Bordeaux with a light sole, something may be lost through a bad pairing.
What features of an asset will determine its ideal capital structure? The
literature on this topic is vast, and I will not attempt to discuss every
consideration in detail. But it seems that an efficient match will depend on
at least three different factors: (1) the “transparency” of assets, or the ease
with which they can be valued and monitored; (2) the liquidity of assets (or
of their associated cash flows); and (3) the volatility (or riskiness) of
assets.57
First, opaque assets, such as those owned by cutting-edge biotechnology
firms, may lend themselves to a different type of capital structure than
transparent assets with long performance histories.58 This is primarily due to
the fact that the opaque assets foster greater information asymmetries
between owner and manager. In other words, investors will be (more)
skeptical about a firm’s representation that unproven assets are valuable.59
55
See Iacobucci & Triantis, supra note 9, 543-44 (2007).
Id. See also OLIVER HART, FIRMS, CONTRACTS AND FINANCIAL
STRUCTURE, 126-51 (1995).
57
Iacobucci & Triantis, supra note 9, at 545.
58
Though a performance history is only relevant to the extent that it helps analysts
understand likely future outcomes. As the financial circulars perpetually warn, “past
performance is no guarantee of future results.”
59
See, e.g., Stewart C. Myers & Nicholas S. Majluf, Corporate Financing and
Investment Decisions When Firms Have Information That Investors Do Not Have, 13 J.
FIN. ECON. 187 (1984); James C. Spindler, IPO Liability and Entrepreneurial Response,
155 U. PA. L. REV. 1187, 1188-89 (2007) (discussing problems with insider
56
15-Feb-08]
The Space Between Markets and Hierarchies
17
Financial contracts will, in turn, presumably benefit from stricter
governance provisions or repayment devices to mitigate investor
discounting related to the claimed value of these securities. A firm with
opaque assets may also benefit more from concentrated ownership
structures—as well as from the use of private debt or equity markets over
public ones.60 By contrast, we should expect firms with transparent assets to
adopt capital structures that are less concerned with these information
problems—because they do not need to invest as heavily in mechanisms
that convince investors they are telling the truth about the value (and future
performance) of their assets.
Second, liquid assets will have different cash flow implications than
illiquid assets—providing another possible basis for variation in capital
structure optimality. A firm with a pile of gold bars, for instance, may be
able to support higher leverage ratios than a firm owning a hard-to-sell
factory. The former can simply liquidate a few ingots when times get tough.
In addition, an asset generating regular cash flows will have implications
for the agency cost problem, because managers will have more “financial
slack” to invest in self-serving projects.61 More debt may be appropriate,
under these circumstances, to tighten this slack via regular interest
payments.
Third, risky or volatile assets will likely merit different financing
treatment than stable ones. Most obviously, assets that are highly sensitive
to exogenous shocks will require more of an equity cushion to shield
against the hazards of financial distress.62 More subtly, managerial agency
costs can become exacerbated with volatile assets; it is harder to monitor
agents when there is plenty of room to blame undesirable outcomes on the
outside world.63 These assets might therefore be financed more efficiently
with governance terms that seek to reduce the information asymmetries
between managers and investors. It is also more expensive to take
concentrated equity stakes in highly volatile firms—because of the
difficulty and downside costs to these investors of remaining
proclamations of value).
60
See, e.g., Douglas W. Diamond, Financial Intermediation and Delegated
Monitoring, 51 REV. ECON. STUD. 393 (1984); Raghuram Rajan & Andrew Winton,
Covenants and Collateral as Incentives to Monitor, 50 J. FIN. 1113 (1995).
61
Iacobucci & Triantis, supra note 9, at 548-49.
62
See, e.g., Dougals G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55
STAN. L. REV. 751, 778 (2002) (“Just as modern cars are designed to take account of the
possibility that they might crash, modern capital structures are designed with the possibility
of financial distress in mind.”).
63
See Edward M. Iacobucci & Ralph A. Winter, Asset Securitization and Asymmetric
Information, 34 J. LEGAL. STUD. 161 (2005).
18
George S. Geis
[15-Feb-08
undiversified.64 For these and other reasons, it may be more efficient to
finance highly volatile assets with lower debt ratios and widely dispersed
equity.
This brief discussion only scratches the surface of the work in this area,
and other features of an asset may also impact capital structure choices.
Furthermore, as mentioned earlier, legal rules governing tax liability,
bankruptcy costs, and other corporate obligations should also play a
significant role in determining leverage ratios and other capital structure
features. My point here is simply that even taking these laws into account,
optimal capital structure remains a function of asset type.
2. Intra-Firm Barriers to Capital Structure Granularity
Edward Iacobucci and George Triantis have recently seized upon this
asset-dependant nature of capital structure design to arrive at an intriguing
explanation for the boundaries of a firm.65 The key to their argument rests
on the fact that capital structure decisions are not tied to individual assets—
but must generally be taken at the highest levels of a firm.66 Debt financing,
for instance, permeates an entire corporation. This obviously means that
creditors cannot reach assets outside the firm.67 But they can (typically) get
at all assets inside the firm if repayment is not forthcoming. Of course
creditors might secure their debt with collateral assets; yet they will still
retain the right to enforce repayment beyond these assets.68 The closest
firms can come to asset-specific financing is probably via nonrecourse
secured debt, but even this form of lending does not always sever the ability
of creditors to garnish other assets.69 More to the point, governance features
on debt—such as covenants to maintain healthy financial ratios or promises
to avoid unrelated lines of business—necessarily attach to the firm as a
64
See Harold Demsetz & Kenneth Lehn, The Structure of Corporate Ownership:
Causes and Consequences, 93 J. POL. ECON. 1155 (1985).
65
Iacobucci & Triantis, supra note 9.
66
Id. at 518.
67
This insight forms the basis of Hansmann and Kraakman’s work on the benefits of
placing diverse assets in different legal entities to capitalize on specialization in monitoring
skills. See Henry Hansmann & Reinier Kraakman, The Essential Role of Organization
Law, 110 YALE L.J. 387 (2000).
68
Indeed, secured creditors may be entitled to enforce the debtor’s personal obligation
before demanding repayment from the securitized collateral. See U.C.C. § 9-601(a)(1)
(2002); Iacobucci & Triantis, supra note 9, at 529.
69
This is obviously true if nonrecourse lenders negotiate for contingencies that trigger
full recourse. More directly, a number of legal doctrines provide personal debtor liability
for fraud, waste, or failure to prudently manage the collateral assets. See Gregory M. Stein,
The Scope of Borrower’s Liability in a Nonrecourse Real Estate Loan, 55 WASH. & LEE.
L. REV. 1207 (1998); Iacobucci & Triantis, supra note 9, at 529-30.
15-Feb-08]
The Space Between Markets and Hierarchies
19
whole, not to individual assets.
Similarly, equity financing is also conducted at a firm-wide level.
Shareholders maintain an interest in all of the firm’s property, and
governance features, like a staggered board of directors or poison pill, are
imposed systemically. Relative participation and control rights can be
altered, of course, with preferred stock or multiple classes of common
stock; but these different classes of shareholders continue to enjoy an
undivided interest in all of the firm’s assets.70 Tracking stocks do offer
some promise of more granular equity arrangements—as they approximate
the partitioning of a firm’s assets by granting shareholders returns based on
the performance of a division within the firm. But even these securities are
not completely divisible from the rest of a corporation because tracking
stock-holders lack dissolution rights, robust fiduciary protection, and other
benefits of equity ownership.71 Thus for both equity and debt, capital
structure decisions must be taken at the very highest levels.
According to Iacobucci and Triantis, the upshot of this legal barrier on
granular capital structure design is that firms will be forced to adopt
blended capital structures as a compromise approach for financing diverse
clusters of internal assets.72 This is not necessarily a bad thing—as firms
will sometimes benefit from tax savings,73 the ability to bear higher
leverage ratios,74 or other conceivable advantages.
Yet it should not be too hard to see how inefficiencies may arise as the
result of this forced compromise. Blended capital structures will sometimes
generate deadweight loss when compared to an alternative arrangement
where heterogeneous assets are split into separately funded firms. Some
divisions may suffer from debt covenant restrictions, for example, that are
primarily designed to tighten the noose on other clusters of assets. Or one
group of assets might conceivably benefit from strong anti-takeover
defenses,75 while the rest of a firm’s assets would be worth more
unburdened by a poison pill.76 Indeed, any of the variables linking asset
70
Iacobucci & Triantis, supra note 9, at 535.
Id. at 536-37. See also, Jeffrey J. Haas, Directorial Fiduciary Duties in a Tracking
Stock Equity Structure: The Need for a Duty of Fairness, 94 MICH. L. REV. 2089 (1996)
(describing some of the legal and economic limits on the use of tracking stocks to achieve a
full partition).
72
Iacobucci & Triantis, supra note 9, at 545-46.
73
For example, interest expenses tied to the financing of new assets generating present
losses may be used to immediately offset tax liability from mature, profitable assets.
74
This might be true if assets are uncorrelated in the timing of their cash flows, such
that one cluster’s gains might be used to support interest payments during another cluster’s
losses.
75
Perhaps because these assets are highly susceptible to inefficient takeover bids
seeking private gains. Iacobucci & Triantis, supra note 9, at 557.
76
The more general question of whether a poison pills increases or decreases a firm’s
71
20
George S. Geis
[15-Feb-08
characteristics to capital structure design might be compromised through a
blended structure. Yet because financing must generally be implemented on
a firm-wide basis, the only elegant solution to this problem is legal
partition.
Anyone setting the borders of a firm may therefore need to include still
another set of variables in their algorithms: the extent to which asset
clusters are likely to vary in their optimal capital structure parings. In other
words, a firm with a fairly homogeneous collection of assets—such as a
lumber yard or accounting firm—may be easily matched to its efficient
capital structure. By contrast, a firm with more diverse assets may suffer
from a suboptimal capital structure by keeping the assets together, instead
of splitting them into more granular legal entities. This is not to say,
however, that heterogeneous assets should never be assembled within a
single firm. It may be quite important to maintain unified ownership in
order to avoid other transaction costs, including the hold-up problem.77 But
this mismatch between capital structure and asset characteristics should be
considered another potential cost to the legal centralization of economic
activity.
In summary, the capital structure theory of the firm might be seen as a
union of the concerns posited by the transaction cost and agency cost
theories. On the one hand, efforts to protect against the hold-up problem
(and other forms of transaction costs) will push toward the intra-firm
aggregation of assets. On the other hand, bundling heterogeneous assets into
a single legal entity may result in capital structure inefficiencies as owners
lose the ability to write the best financing contracts for mitigating agency
distortions. Undoubtedly, some large firms will have asset clusters with
similar levels of opacity, liquidity, and volatility—and will therefore suffer
very little from a blended capital structure. Other firms, however, may find
it necessary to own assets that are uncorrelated in these features. These
organizations must therefore trade the hold-up problem against the agency
cost problem (along with any other distortions arising from blended capital
structures) in order to determine exactly where to position their legal
borders.
But this dichotomy between market transactions and firm hierarchies
has always been something of an oversimplification. Firms don’t just shove
value is heavily debated. See, e.g., FRANK H. EASTERBROOK & DANIEL R.
FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 168-74 (1991)
(arguing that anti-takeover defenses, such as a pill, should reduce firm value); John Coates
IV, Takeover Defenses in the Shadow of the Pill: A Critique of the Scientific Evidence, 79
TEX. L. REV. 2 (2000) (challenging work linking poison pill adoption to a decrease in
firm value).
77
See infra Part I.A.
15-Feb-08]
The Space Between Markets and Hierarchies
21
economic activity to one side of the line or the other; they have a wide
range of hybrid structures with which to conduct their affairs. These include
strategies like joint ventures, business alliances, minority equity
investments, and franchise agreements. While the exact details of these
various mechanisms differ, each offers firms a middle path, strewn with
some of the benefits (and costs) of open market transactions and internal
ownership. In short, there is space between markets and hierarchies. Of
course, I am hardly the first person to make this observation—so let me
round out this brief discussion of organizational theory by turning to recent
work on hybrid entities.
D. Hybrid Organizational Entities
Foundational research on the theory of the firm accepts that there is
room for organizational compromise between arms-length “spot” contracts
(on one end of the spectrum) and total firm integration (on the other).78 But
the exact rationale for this compromise—or the key parameters constituting
the dividing lines between different “flavors” of hybrid entities—is rarely
articulated in much detail. Instead, most of the economic and management
research wrestling with hybrid entities takes the form of empirical analysis.
To understand this work, then, it is necessary to step back for a moment
and consider the overall empirical project related to “make-or-buy”
production decisions.79 The primary goal of this scholarship is to test
whether observed organizational choices can be explained by the key
variables thought to lie underneath the tradeoffs inherent in economic
organization.80 Thus, a transaction that seems especially likely to present
hold-up problems—perhaps because it involves intense combinations of
relation-specific assets, or high degrees of uncertainty and complexity—is
expected to be “made” within a firm.81 Conversely, economists would
predict that a transaction lacking most of these elements will be “bought”
78
See sources cited supra note 26.
For helpful reviews of empirical work in this area, see Paul Joskow, Asset Specificity
and the Structure of Vertical Relationships, 4 J. L. ECON. & ORG. 95 (1988); Peter G.
Klein, The Make-or-Buy Decision: Lessons from Empirical Studies, in HANDBOOK OF
NEW INSTITUTIONAL ECONOMICS 435-64 (Claude Ménard & Mary Shirley, eds.,
2005); Howard A. Shelanski & Peter G. Klein, Empirical Research in Transaction Cost
Economics: A Review and Assessment, 11 J. L. ECON. & ORG. 335 (1995); Jeffery T.
Macher & Barak D. Richman, Transaction Cost Economics: An Assessment of Empirical
Research in the Social Sciences (forthcoming 2008) (expanding the review to include work
in the social sciences beyond the fields of economics and management).
80
See Shelanski & Klein, supra note 79, at 336-37.
81
See, e.g., Macher & Richman, supra note 79, at 2-3.
79
22
George S. Geis
[15-Feb-08
outside of the firm.82 In other words, scholars consider organizational form
as the dependent variable, while treating critical transactional properties—
such as asset specificity, uncertainty, complexity, and interaction
frequency—as the independent variables.83 Hundreds of these empirical
studies have been conducted, ranging from rigorous econometric exercises
to anecdotal case interviews.84 And while the work is open to different
interpretations, the evidence here does seem to suggest that, as predicted,
key theoretical variables play a significant factor in the selection of
transactional form.85
Most of these empirical studies adopt a simple binary variable (“make”
or “buy”) in their analysis.86 Yet it should not be too hard to imagine how
scholars might extend this methodology to study hybrid entities.
Intermediate transactional forms could be divided, for instance, into
different classes of relationships—ranging from closely integrated joint
ventures to looser, long-term contracts or informal alliances. Empiricists
can then examine, as before, the key variables underlying these transactions
to test whether hybrid form follows function.
Consider, for example, a 1997 study by Joanne Oxley examining
technology transfer partnerships.87 After compiling a database of roughly
9000 transactions, Oxley clustered the hybrid relationships into three broad
82
Id.
Shelanski & Klein, supra note 79, at 338. In addition, empirical researchers will
typically include variables in their models to control for effects related to industry, firm
size, and other descriptive features.
84
See Macher & Richman, supra note 79, at 1-2 (cataloging approximately 900
articles on transaction cost economics across a variety of disciplines); Shelanski & Klein,
supra note 79, at 338-39 (classifying research methodologies into qualitative case studies,
quantitative case studies, and cross-sectional econometric analyses).
85
See, e.g., Shelanski & Klein, supra note 79, at 336 (reviewing the research and
concluding that “a remarkable amount of the empirical work … is consistent with TCE
predictions—much more so, perhaps, than is the case with most of industrial
organization.”); Oliver E. Williamson, The New Institutional Economics: Taking Stock,
Looking Ahead, 38 J. ECON. LIT. 595, 607 (2000) (“Those who have done this modest,
slow, molecular, definitive work deserve enormous credit.”).
86
Shelanski & Klein, supra note 79, at 338. The typical approach is to acknowledge
the possibility of intermediate hybrid structures (or multi-sourcing strategies where a firm
both makes and buys a given input)—but then simplify the analysis into a dichotomous
choice between firm and market production. See, e.g., Anne Parmigiani, Why do Firms
Both Make and Buy? An Investigation of Concurrent Sourcing, 28 STRAT. MGMT. J. 285,
287 (2007). For example, in a classic empirical study, Monteverde and Teece define
“make” as when a firm performs 80 percent or more of an activity and “buy” as when the
firm performs less than this amount. Kirk Monteverde & David J. Teece, Supplier
Switching Costs and Vertical Integration in the Automobile Industry, 13 BELL. J. ECON.
206 (1982).
87
Joanne E. Oxley, Appropriability Hazards and Governance in Strategic Alliances: A
Transaction Cost Approach, 13 J. L. ECON. & ORG. 387 (1997).
83
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The Space Between Markets and Hierarchies
23
categories: “unilateral” contracts such as licensing agreements or R&D
services; “bilateral” contracts88 such as cross-licensing agreements or joint
research efforts; and “equity-based” alliances such as independent joint
ventures.89 The first class of hybrid transactions was said to lie closer to the
extreme of spot-market exchange, while the latter class approached an intrafirm hierarchical arrangement. Oxley then proposed a series of hypotheses
linking observable characteristics to organizational form—for example, an
equity-based relationship might be more likely to occur with deals
involving product design90—and ran statistical analyses to test her
predictions.91 Ultimately, she found that the form of alliance did seem to
depend on transactional attributes—and not on other characteristics of the
partner firms.92 Other empirical projects on hybrid organization follow in
this same tradition.93
Unfortunately, however, this empirical work suffers from two thorny
problems—the first common to all empirical research in this area, and the
second unique to the hybrid context. The first concern: it is exceptionally
difficult to measure the independent variables. How, for example, can
researchers possibly determine whether one transaction involves especially
high levels of relationship-specificity? Similarly, it is hard to assess
economic complexity or uncertainty in any standardized or systematic
manner. These concerns have not deterred economists, of course, and a
wide range of survey techniques94 or creative proxy variables95 are used to
88
The use of the terms “unilateral” and “bilateral” apparently relate to the identity of
the parties supplying the technology—and not to their more specialized meanings in
contract law.
89
Oxley, supra note 87, at 391-92.
90
See Id. at 395 (“a more hierarchical governance mode will be chosen when an
alliance involves product or process design than when only production or marketing
activities are undertaken.”).
91
The key independent variables in this study include transaction type (design,
production, marketing, etc.), technological scope, geographical scope, and the number of
partners in the agreement. Control variables are used for industry, firm size, and previous
R&D experience. See Oxley, supra note 87, at 397-401.
92
Id. at 406. It is worth noting, however, that Oxley also qualified her results due to
limited information about some transactions.
93
See, for example, P. LORANGE & J. ROOS, STRATEGIC ALLIANCES:
FORMATION, IMPLEMENTATION AND EVOLUTION (1992); R. Gulati, Does
Familiarity Breed Trust? The Implications of Repeated Ties for Contractual Choice in
Alliances, 38 ACADEMY MGMT. J. 85 (1995); G. Pisano, Using Equity Participation to
Support Exchange: Evidence from the Biotechnology Industry, 5 J. L. ECON. & ORG. 109
(1989); G. Pisano, The R&D Boundaries of the Firm: An Empirical Analysis, 35 ADMIN.
SCI. Q. 153 (1990).
94
One common approach is to survey the managers involved in a database of
transactions, asking them to rate various deals (usually on Likert-type scales) in terms that
can be translated into asset specificity. For example, “to what degree does this investment
24
George S. Geis
[15-Feb-08
finesse this problem. Ultimately, however, it is fair to question whether
researchers are really measuring variables that can be linked back to the key
considerations underlying the theory of the firm.
The second problem, unique to research on hybrid organizations, relates
to the granularity of the dependent variable, or, said differently, the number
and type of transaction classes. Should researchers divide hybrid
organizational structures into three broad classes or ten? And how should
they determine the salient characteristics that distinguish one class of entity
from another?96 The typical response is to group a complete spectrum of
hybrid transactions into a few broad flavors. But these relationships are
complicated, and this approach may miss some important nuances. In short,
it can be exceptionally difficult to draw grand conclusions from a high-level
examination of this varied terrain—and I am skeptical that a three or fourpart division of hybrid organizations provides sufficient granularity to
meaningfully assess the diversity of contracting arrangements.
For these reasons, I would contend that it is important to focus more
have uses outside the specific transaction. Please answer from 1 (no outside uses) to 7
(complete fungible)” Of course, the subjective nature of these surveys makes it futile to
compare the studies across industries. And the self-reported nature of this data introduces
the usual risks of bias.
95
The Oxley study, for instance, hypothesizes that technology design partnerships are
more likely to involve relation-specific assets than production or marketing deals. See
supra note 90. Other studies select proxy variables that may be directly related to elements
of asset specificity. See, e.g., Paul Joskow, Vertical Integration and Long-Term Contracts:
The Case of Coal-Burning Electric Power Plants, 1 J. L. ECON. & ORG. 33 (1985) (using
physical proximity, or site specificity, as a proxy for relationship-specific investment); Paul
Joskow, Contract Duration and Relation Specific Investments: Empirical Evidence from
Coal Markets, 17 AM. ECON. REV. 168 (1987) (same); Palay, supra note 97 (using
idiosyncratic investments as a proxy variable); Scott E. Masten, The Organization of
Production: Evidence from the Aerospace Industry, 27 J. L. & ECON. 403 (1984) (using
product complexity as a proxy variable); J.H. Dyer, Does Governance Matter? Keiretsu
Alliances and Asset Specificity as Sources of Japanese Competitive Advantage, ORG. SCI.
7 (1996) (using inter-firm co-specialization as a proxy variable); Scott E. Master et al., The
Costs of Organization, 7 J. L. ECON. & ORG. 1 (1991) (using spatial or temporal
proximity as a proxy variable). There are conceptual concerns, however, with some of
these proxy variables, and the extent to which researchers are measuring hold-up risk is
ultimately debatable. See, e.g., Shelanski & Klein, supra note 79, at 339-41; Klein, supra
note 79, at 451-53.
96
Oxley puts the problem this way: “making fine-grained assessments of the
governance attributes of a particular alliance requires information on a long ‘list’ of
features, including formal and informal monitoring or reporting requirements, provisions
for third-party arbitration, details of assignments of managerial control rights, and the
extent of effective hostage exchanges built into the agreement. Moreover, even with all the
necessary data in hand, it is not clear how we compare two alliances in which different
combinations of these various governance mechanisms are present.” Oxley, supra note 87,
at 391.
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The Space Between Markets and Hierarchies
25
closely on specific types of hybrid relationships.97 Such efforts may make it
easier for scholars to articulate the exact theoretical benefits of intermediate
economic arrangements—as well as to conduct the empirical analysis
needed to test finer grained distinctions.98 The balance of this paper, then,
takes up this strategy by conducting a more detailed examination of one
hybrid relationship that has started to attract enormous attention—whether it
is discussed in the corporate boardroom or in the private living room. I am
talking, of course, about business outsourcing.
II. THE OUTSOURCING REVOLUTION
Over the past decade, we have seen an unprecedented rise in offshore
transactions.99 The conventional explanation for this trend is simply that
firms are seeking to arbitrage labor costs. Yet this phenomenon is about
more than basic cost savings, and managers are finding it worthwhile to
source production in new corners of the globe for other reasons. For
example, some companies wish to tap into regional areas of expertise, such
as those offered by Indian pharmaceutical scientists or Chinese embedded
software programmers.100 Other businesses are moving overseas to establish
a marketing beachhead in the pursuit of new customers.101 They are finding
it easier to build brand recognition, market knowledge, and customer
loyalty with a local production presence. In still other cases, legal, political,
or regulatory differences around the world may be driving the offshoring
decision.102
97
For some examples of articles taking this approach, consider Jan Heide & George
John, Alliances in Industrial Purchasing: The Determinants of Joint Action in BuyerSupplier Relationships, 27 J. MKTG. RES. 24 (1990) (focusing on informal marketing
alliances); Saul Klein et al., A Transaction Cost Analysis Model of Channel Integration in
International Markets, 27 J. MKTG. RES. 196 (1990) (focusing on the use of joint
ventures—where an independent firm is established by two or more principals to conduct
an economic activity); Thomas Palay, Comparative Institutional Economics: The
Governance of Rail Freight Contracts, 13 J. LEGAL. STUD. 265 (1984) (focusing on
relational contracting).
98
I will return to the empirical project infra Part IV.
99
See supra notes 2-7 and accompanying text.
100
See sources cited supra note 5.
101
The McKinsey Global Institute, for example, describes how the attractiveness of
local markets plays a part in the selection of a location for offshore work. See, e.g., Diana
Farrell, Smarter Offshoring, HARV. BUS. REV. (Jun. 2006).
102
The income tax advantages available through China’s special economic zones are
one example of this. See Vietor & Veytsman, supra note 2, at 7-8. Similarly, Ireland has
attracted a significant amount of economic activity, especially in the high technology
sector, by offering tax benefits to firms conducting European sales through an Irish
subsidiary. See, e.g., Glenn R. Simpson, Wearing of the Green: Irish Subsidiary Lets
Microsoft Slash Taxes in U.S. and Europe, WALL ST. J., at A1 (Nov. 7, 2005).
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George S. Geis
[15-Feb-08
When analyzing any relocation decision, it is important to start with a
careful organizational taxonomy. For firms looking overseas have a
choice—as they do with any other economic endeavor—whether to perform
this activity internally, by setting up a captive offshore center, or whether to
move it outside the corporate fold through arms-length transactions. In
order to understand the entire game-board, then, we must distinguish the
offshoring and outsourcing decisions.
A. Distinguishing the Offshoring and Outsourcing Decisions
A determination to relocate economic production immediately raises
two follow-on questions. First, should the firm continue to perform the
activity onshore—that is, in the country where the product will be sold—or
should it move the activity to an offshore location? Second, should the firm
retain legal control of the business activity, or should it outsource the job to
another corporation? Putting these two dimensions together leaves a firm
with the four dichotomous choices portrayed in Figure 1.
LAN020213287-23884-ZXK
Figure 1. Options for Restructuring a Remote Activity
To briefly illustrate the differences, a firm may engage in shared
services by centralizing some activity, say human resources, into a nearby
corporate headquarters. Instead of having one or two HR managers at every
branch, it simply gathers a dozen employees at corporate. Alternatively, the
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The Space Between Markets and Hierarchies
27
firm could employ the same managers at a division of the firm in Manilla
(captive offshoring). Third, it could divest all of this HR work to a different
company, located across town (onshore outsourcing). And finally, it could
contract with a firm in India to take on these responsibilities (offshore
outsourcing). Each of these options presents a viable strategy, but my
primary focus is on the left vertical axis. Of course, this is just a rephrasing
of the central question underlying the theory of the firm: what activity
belongs within the corporate fold?
In the real world, however, the division is rarely so sharp as that
suggested by Figure 1. Some offshoring will indeed remain safely within
the legal boundaries of a firm via captive expansion. Other transactions may
completely jettison the features that we typically think of as defining
corporate ownership: control, residual equity rights, risk, and so forth. Yet
many offshoring relationships straddle this line—with mixed elements of
ownership and control that are analogous to joint ventures or business
alliances. The Wachovia and Genpact outsourcing deal described earlier is
one example of this.103 Let me briefly offer another.
In 1995, a California firm named HireRight brought a novel business
model to market: it would assist companies in their recruiting efforts by
providing background checks, drug screening, and other services related to
the hiring of prospective employees. HireRight grew rapidly, largely
through the development of proprietary technology that automated its
services and linked the results directly into a client’s HR database. By 2007,
HireRight served approximately ten percent of companies in the Fortune
500 and had floated an initial public offering on the NASDAQ.104
Two years earlier, HireRight had decided to outsource some of its back
office operations. It partnered with a vendor in Mumbai named TransWorks
Information Services (“TransWorks”).105 TransWorks would assist
HireRight with many different tasks, including making telephone calls to
verify employee data, researching employee information online, and
performing data entry. The quantity of work would be variable: HireRight
would provide TransWorks with rolling volume projections, and the Indian
company would allocate staff to the job as necessary.106
Like many outsourcing clients, HireRight insisted on detailed service
level requirements related to the volume and quality of work performed by
103
See supra notes 13-21 and accompanying text.
See
HireRight
Investor
FAQ,
available
at
http://ir.hireright.com/phoenix.zhtml?c=209077&p=irol-faq.
105
See http://contracts.onecle.com/hireright/transworks-services-2005-02-03.shtml.
TransWorks was a subsidiary of the Aditya Birla Group, a leading Indian business
conglomerate.
106
Id. at Schedule B.
104
28
George S. Geis
[15-Feb-08
TransWork’s employees. It also required TransWorks to submit daily or
weekly reports related to its performance—including information on
employee tardiness, absenteeism, and productivity. Interestingly, third party
monitors and standards were also used to verify operational quality:
TransWorks represented that it followed several international data norms,107
and it agreed to charter semi-annual audits by Ernst & Young (or
comparable auditors) to verify ongoing compliance with these standards.108
Beyond these detailed requirements, however, HireRight also obtained
broader control rights related to the manner in which TransWorks would
carry out this activity. For example, the California client could approve the
appointment of the overall program manager who would run the project in
Mumbai. Similarly, the parties established a pool of “dedicated personnel.”
Every employee meeting this classification was assigned, on a full-time
basis, to the HireRight account. Further, the client approved the
appointment of each dedicated employee and enjoyed the discretion to
terminate each employee’s affiliation with the project (for reasonable
cause). With respect to the procedures used to perform the work, HireRight
installed specific “change control procedures” forbidding modification of
assignments without explicit approval.109
Any nuanced relationship of this sort establishes an economic
partnership that is arguably more than a market transaction, yet still
something less than a fully-owned subsidiary. To be sure, anything short of
captive custody might technically be considered a contractual exchange
(and thus a form of arm’s length transacting). Yet there are many variants
along this spectrum—and it is worth exploring how and why firms divide
organizational governance through hybrid outsourcing deals. The answer, as
it turns out, is that these arrangements can offer a compromise among the
tensions outlined in Part I of this article. But before describing the essential
features of this governance compromise, let me quickly review the legal
structure of outsourcing transactions.
B. The Legal Structure of Outsourcing
Business outsourcing has evolved over time, but the basic contractual
framework often remains the same.110 The partners will typically negotiate
107
These included ISO 17799, US-GLBA, and the UK-DPA. Id. at Article 21.02 (k).
Id. at Article 21.02 (l).
109
Id.
110
I describe and illustrate this contractual framework more fully in George S. Geis,
Business Outsourcing and the Agency Cost Problem, 82 NOTRE DAME L. REV. 955,
984-89 (2007).
108
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The Space Between Markets and Hierarchies
29
four distinct documents.111 First, they will often sign a confidentiality
agreement before pursuing more substantive negotiations. This is especially
important when an outsourcing client bargains simultaneously with several
potential vendors to take over a sensitive part of the business.
Second, the firms will normally draft a “master agreement” establishing
the broad contours of their relationship.112 This lengthy contract defines the
general category of activities to be outsourced and provides an anticipated
timeline for moving forward with the relationship. Importantly, the master
agreement is rarely used to delineate the specific activities to be
outsourced—that will come later. But it does set an overall governance
structure for the project, usually by establishing high level review boards,
dispute resolution mechanisms, fee arrangements, and bilateral termination
rights.
The third type of document used to govern the outsourcing relationship
is the work statement. This is where the rubber hits the road, and parties to
complicated outsourcing projects will often negotiate (and revise) many
different work statements to define or alter the scope of a relationship.
These contracts are short, modular agreements that are typically developed
by mid-level managers to set the precise duties, and hand-off points,
between client and vendor. They are also likely to change over time, as a
partnership grows or shrinks.
Finally, the parties will draft a service level agreement (“SLA”) to
govern the quality of work. If the work statements define “what will be
done,” then the SLA defines “how well it will be performed.” In other
words, the SLA provides benchmarks for acceptable outcomes, along with
reporting metrics and requirements, penalty clauses, and (perhaps) dispute
resolution procedures.113 Obviously, an SLA will evolve as work statements
change.
It is worth noting that the overall structure of this relationship can play a
meaningful role in protecting both parties from opportunism. I have argued
elsewhere, for example, that the ability to expand or retract the scope of a
project (through additions or amendments to the statements of work) acts as
a form of staged commitment.114 In other words, the parties may have room
to adjust the depth of their relationship as additional information sheds light
on the quality of each counterparty.
111
Of course, in practice there may be more or less than four different contracts
because the parties will sometimes combine one or more of these agreements into a single
document (typically via postscript attachments) or split them into many separate ones.
112
E.g., Amended and Restated Global Master Services Agreement Between Coors
Brewing Company and EDS Information Services, L.L.C. dated Jan. 1, 2004, available at
http://contracts.onecle.com/coors/eds.svc.2004.01.01.shtml.
113
These terms are sometimes set out instead in the master agreement.
114
See Geis, supra note 110, at 984-89.
30
George S. Geis
[15-Feb-08
Of course, the specific terms in these contracts will play the greatest role
in allocating control and ownership between the parties.115 For example,
firms may draft contractual provisions ceding control rights to a client—
either by mandating exact requirements for ongoing performance, or by
replacing detailed contracts with procedural carve-outs that convey explicit
authority over vendor decisions related to the work. Third-party auditors or
international standards may also be used to verify (or establish)
performance benchmarks.116
Alternatively, the parties may structure their affairs to grant a vendor
partial “ownership” over the results of its decisions through incentive
compatible compensation. Just as a corporation issues options to top
managers to focus their efforts on boosting stock prices,117 an outsourcing
client might seek to share economic improvements with a vendor—or
award an “earn-out” bonus for especially skillful work. These strategies will
never work perfectly,118 but they may help to focus the attention of both
parties on similar goals.
Beyond these precise contractual details, however, looms a much larger
question: why are these deals even taking place? In other words, are
outsourcing projects just a cost arbitrage game? Or might they also serve a
more meaningful governance function that links into legal and economic
theories of the firm?
C. Outsourcing as a Governance Compromise
In this section, I will argue that business outsourcing (or, for that matter,
other hybrid organizational structures) can add value—under the right
circumstances—by allowing firms to fashion an efficient governance
compromise between markets and hierarchies. This can be true for four
reasons. First, business outsourcing helps firms reintroduce some market
discipline into production decisions. Second, it can reduce the hold-up
problem that arises with market transactions. Third, it can mitigate the
corporate agency cost problem. And fourth, it can allow firms to better
attune their capital structures to underlying asset characteristics. The
115
As mentioned earlier, a detailed empirical examination of outsourcing contracts
exceeds the scope of this article.
116
See Margaret M. Blair et al., The New Role for Assurance Services in Global
Commerce, J. CORP. L. (forthcoming 2008).
117
See Jensen & Meckling, supra note 35; Michael C. Jensen & Kevin J. Murphy,
Performance Pay and Top-Management Incentives, 98 J. POL. ECON. 225, 261 (1990).
118
Anything short of transferring a complete ownership interest to the agent-vendor
will leave some room for mischief. See, e.g., Robert H. Sitkoff, An Agency Costs Theory of
Trust Law, 69 CORNELL L. REV. 621, 636-37 (2005) (illustrating numerically why this is
true).
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The Space Between Markets and Hierarchies
31
decision to pursue a hybrid outsourcing transaction can therefore be seen as
an attempt to compromise among each (or all) of these four dimensions.
As is so often the case, however, compromise is unlikely to offer the
first-best solution along any single dimension. It will almost never lead to
the cheapest possible input prices, the ideal capital structure, or a foolproof
shield against opportunistic renegotiation. But, taking all of the relevant
variables into account, an intermediate approach will sometimes be better
than pursuing more extreme strategies of firm ownership or simple
contracting. These conditions are not universally present, of course, and I
will also discuss situations where the variables might caution against
compromise. But first, let me analyze each of these theoretical
considerations in more detail.
1. Seeking Market Discipline for Input Prices
The first advantage of business outsourcing comes from an ability to
reintroduce some market discipline into production decisions and input
prices. This follows directly from Coasean notions of the firm: the
outsourced activity no longer enjoys a guaranteed internal “sale,” and
economic actors will therefore have new incentives to avoid the
inefficiencies that can fester with complacency.119 This is not to say,
however, that outsourcing transactions offer as much pricing discipline as
frequent spot market exchange. As described above, an outsourcing deal is
often contemplated as a longer-term affair—which may provide vendors
with at least partial shelter from market forces. It is certainly harder to
abandon these ventures than to, say, start buying gasoline from a different
filling station.
Nevertheless, there are still practical reasons to believe that business
outsourcing can act as a crucible for the fires of market pressure in a way
that internal ownership will not. These relationships are subject to careful
upfront negotiation and back-end renewal decisions. They often face
frequent and explicit performance evaluation—through detailed service
level agreements120—in a way that is much less common with internal firm
activity. Moreover, firms will sometimes use explicit strategies to
reintroduce market pressure, such as securing exit options121 or hiring
multiple outsourcing vendors to perform the same (or very similar) tasks.122
The net effect, then, is an organizational structure that arguably provides
less market pressure than spot contracting but more pressure than captive
119
See Coase, supra note 24, at 390.
See supra Part II.C.
121
See Geis, supra note 110, at 994-97.
122
Id. at 989-91.
120
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George S. Geis
[15-Feb-08
retention of a given business activity.
2. Mitigating the Hold-Up Problem from Specialized Investment
The second theoretical benefit of hybrid outsourcing involves partial
mitigation of the hold-up problem. Recall that one primary justification for
intra-firm production is that ownership nullifies a risk of counterparty
renegotiation to expropriate gains from specialized asset combinations.123 In
other words, firms might logically choose to incur slightly higher
production costs via internal ownership in order to comfortably make
relation-specific investments that will maximize the value of uniquely
complimentary assets.
In this context, business outsourcing can again play a compromise role
by offering a firm partial protection against the hold-up problem. This is
true because an outsourcing partnership, unlike a simple supply contract,
allows the partners to carve out enumerated spheres of control, into which
they can more safely place relationship-specific investments. This will
usually afford less protection than integrating the assets into one legal
organization—an outsourcing arrangement is not a complete shield against
the hold-up problem—but the ability to limit a firm’s exposure to some
categories of opportunism can still generate relief.
Recall, for example, the outsourcing partnership between Wachovia
Bank and Genpact—under which the Indian firm would redesign and
manage much of Wachovia’s back-office operations.124 The relationship
was replete with hold-up risk: the parties were not able to completely spell
out the scope of their relationship, and Genpact might easily have sought to
extract future profits from a specialized investment that would interact
uniquely with the back office systems. From Wachovia’s point of view, the
safest solution would be to retain ownership of this business activity to
protect against an extortion risk. Yet the bank had other good reasons to
move these services outside the firm, even if doing so would necessarily
expose it to potential hold-up liability.
It finally settled on a strategy where the business would be moved to
Genpact, but Wachovia would retain control over certain governance
features—such as the way that key activities were conducted and the
selection of top managers. It also signed a seven-year contract.125 The net
result, then, was an arrangement where Wachovia continued to face hold-up
risk for activity outside these spheres of control. But it enjoyed at least
partial protection against opportunism for actions relating directly to these
123
See supra Part I.A.
See supra notes 13-21 and accompanying text.
125
See supra note 21.
124
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The Space Between Markets and Hierarchies
33
reserved niches of discretion.
3. Narrowing the Scope of Agency Distortions
The third way that outsourcing can compromise between markets and
hierarchies relates back to the agency cost problem and the possibility that
controlling managers will take selfish action at the expense of firm owners.
The intuition here should be quite straightforward: pulling a given activity
away from managerial discretion curtails the agent’s flexibility to pursue
bad decisions. In other words, this supervisory freedom (and the resulting
likelihood of information asymmetry) is pruned back and replaced with
narrowly tailored contracts to govern the elements of production.126
It is important to recognize, however, that moving an activity out of the
corporate fold via outsourcing might simply substitute one strain of the
agency cost problem with another. Within the firm, managerial abuse of the
activity may be narrowed. But a new problem might arise, like a phoenix
from the ashes, under the guise of the promisor-promisee relationship. For
long-term promisors, just like firm managers, can also be seen as agents—
with incentives to shirk or cut corners when they control business activity
that will affect the fortunes of a promisee (in this case, the outsourcing
client).127 This means that an outsourcing vendor may make poor choices ex
ante (from the client’s point of view) and then use information asymmetries
to blame bad ex post outcomes on external factors.
Therefore, in order for business outsourcing to provide much relief from
the agency cost problem, additional structural or contractual mechanisms
must be put in place to provide boundaries on vendor discretion. And here,
there is ample evidence that parties do plan their relationships quite
carefully in an effort to mitigate the agency cost problem.128 For this reason,
complex—and carefully negotiated—partnership structures (like
outsourcing) may often pay more attention to agency mitigation strategies
than the open-ended charters granted to internal firm managers.129
126
This argument is thus analogous to a belief that contractual debt is subject to lower
agency risk than broadband equity. See supra notes 48-50 and accompanying text.
127
See Jensen & Meckling, supra note 35.
128
I have discussed five different strategies for mitigating the agency cost problem in
an earlier article. See Geis, supra note 110, at 982-97. Of course, it is theoretically possible
that similar mechanisms could be used to bound the discretion of intra-firm managers
through employment contracts or reporting obligations. The relevant question, then, is
whether it is easier (or more effective) for firms to limit the agency problem via external
contract. The answer to this question may be yes, given the general governance mechanism
of a corporation—which typically conveys broad discretion, by default, to the officers and
managers of a firm.
129
Again, it might be helpful to compare the open-ended relationship of a firm and its
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George S. Geis
[15-Feb-08
4. Fine Tuning Capital Structure to Asset Clusters
Fourth, there is reason to believe that outsourcing and other intermediate
organizational structures can help firms finesse the potential mismatch
between asset characteristics and efficient capital structures. Recall that this
problem arises because firms are generally required under law to make
capital structure decisions (related to both debt and equity) that affect all
internally-owned assets. Yet, as Iacobucci and Triantis have argued, this
will result in inefficiencies through “blended capital structures” if
heterogeneous asset characteristics call for different financing features.130
Splitting diverse assets among several smaller firms (or subsidiaries) should
allow for better pairings, but this then introduces the above-mentioned
transaction cost and hold-up concerns.
Might the use of outsourcing (or other intermediate structures) offer a
way to partially diversify on capital structure without giving up all the
benefits of economic integration? The possibility of efficient compromise
arises because the legal separateness of an outsourcing vendor allows for a
tailored capital structure, while the contractual control rights retained by the
client provide partial defense against the hold-up problem. Thus, an IT
outsourcing vendor may be able to assume conservative leverage ratios
(perhaps because the volatility of its rapidly changing technology assets
calls for such an approach), freeing up an industrial client to take on more
debt to finance its stable assets (or to use tailored debt covenants more
efficiently). The transaction costs to implement this arrangement may be
higher than complete integration—but it may still economize over a
contract that delegates absolute control to a counterparty.
Iacobucci and Triantis do not explore this option comprehensively, but
they briefly raise it as a possibility: “Intermediate structures where control
boundaries span multiple legal entities may not realize the full benefits of
either integration or tailoring, but they may be optimal compromises.”131
equity investors with the more narrowly-bounded relationship between a firm and its
creditors. Equity investors do not typically delineate the bounds of managerial discretion,
beyond reserving control over a few fundamental decisions (like merger transactions).
Conversely, debt investors must resort to contractual bargaining and carefully-wrought
covenants to establish the contours of their governance rights. See Baird & Rasmussen,
supra note 51. Turning from the financing context to the operational context, a firm’s
relationship with internal managers may be more open-ended (like equity arrangements),
while external outsourcing relationship may be more carefully bounded through contract
(like debt).
130
See supra Part I.C.2.
131
Iacobucci & Triantis, supra note 9, at 564. The authors seem to refer primarily to
the use of, and relationship between, parent and subsidiary firms. Yet, the logic should
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35
Outsourcing might be seen, then, as a middle ground approach to this
problem. The paring of capital structure to underlying asset characteristics,
and the advantages of economic integration, will still not be perfect. But
outsourcing might be better (under limited conditions) than either stark
alternative of intra-firm asset integration or arm’s length separation.
5. A Summary Example
A final, stylized example may help to summarize all four of these
theoretical considerations. Take a simple value chain—like the one
portrayed in Figure 2—requiring only three steps (A, B, and C) to transform
raw inputs into finished products. Now imagine three different ways to
organize this economic activity. Option one is to bundle all three steps into
a single firm. Option two is to conduct each step with a different firm. And
option three is to outsource step B but retain steps A and C within one firm.
As Figure 2 shows, there are likely to be different relative costs associated
with each of these modes of production.132
LAN020213287-23884-ZXK
Figure 2. Stylized Outsourcing Example
1. Intra-Firm
A
B
3. Outsourced
2. Inter-Firm
C
A
B
C
A
C
B
Transformation
Costs:
7
Interaction
Costs:
8
5
9
5
5
6
10
7
7
10
7
6
Agency
Costs:
5
2
3
Capital
Costs:
5
0
1
Total
Costs
Total
Costs
Total
Costs
44
40
9
6
39
generalize to business outsourcing transactions and other joint ventures where control and
production is shared among multiple legal entities.
132
Obviously, the numbers here are merely illustrative of the likely relative cost
differences between these three organizational options.
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George S. Geis
[15-Feb-08
Complete integration (option one) should result in higher prices for each
of the three transformation stages. As described earlier, the activity is
shielded from market pressures in a way that does not occur with option
two. Option three retains the lofty internal production costs for steps A and
C, but enjoys slightly lower costs for the outsourced step B.133
The second expense category involves the interaction costs required to
hand off production from one stage of transformation to the next. These
should be understood broadly, to include both negotiation and coordination
costs, as well as any hold-up risk that may lead to investments in
suboptimal, non-specific assets. Option one is likely to enjoy the lowest
interaction costs (for both hand-offs), option two will suffer the highest
costs, and option three will lie somewhere in the middle.
The third and fourth expense categories relate to agency and capital
structure costs. These numbers might be understood as representing the net
harm from inefficient decisions or expensive monitoring (with respect to
agency) and the incremental cost of capital (broadly defined) that must be
incurred when financing cannot be paired optimally with assets. Every
production strategy will face some agency risk, but it will likely hit harder
with option one and lighter with option two (for the reasons described
above). Option three will again lie somewhere in the middle. Similarly,
capital structure costs will theoretically be highest with complete integration
(where blended structures must be maintained) and more moderate with
outsourcing. No capital structure penalty is assumed under option two,
because each of the three firms will presumably optimize for the specific
assets needed to conduct their stage of transformation.
Summing the various costs, under the assumptions of Figure 2, suggests
that outsourcing is the best way to go to market. It is never the cheapest
approach for any single cost component, but the total outlay is minimized
when all factors are considered. Of course these numbers are completely
fictional, and other assumptions would change the results. My point is
simply to illustrate how the relative differences among these key factors
might theoretically commend the use of outsourcing as a sensible
governance compromise.
Much more generally, the space between markets and hierarchies
becomes an attractive location for economic activity when we recognize
that it is possible to assert control, or at least limited control, over the work
of others. To be sure, complex organizational contracting is not costless.
The parties will incur transaction costs to negotiate these deals and agency
costs to monitor them. It may be expensive to coordinate ongoing,
133
The cost of step B in this example is portrayed as slightly higher than in option two
because the outsourcing transaction is assumed to encompass a longer term relationship,
thereby only reintroducing some of the pressures of open-market competition.
15-Feb-08]
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37
bifurcated decision-making authority. And other distortions will likely arise
through information asymmetries. But these costs must be weighed against
the legal and economic benefits of adopting hybrid organizational
structures. There are any number of strategies for parceling out the rewards
and risks of production, and no one way of conducting business perpetually
trumps the alternatives.
All of this contractual flexibility leads into my next set of questions: are
we moving toward a world where firms will enjoy a richer menu of
organizational strategies for reorienting operational risk? If so, what might
this mean for the management and legal apportionment of economic
production?
III. DECONSTRUCTING OPERATIONAL ACTIVITY
A critical simplifying assumption provides the starting point for much
of the work on the firm: market transactions necessarily relinquish control.
Transaction cost scholars justify corporate-owned activity as an antidote to
the hold-out problem arising with a loss of control. Similarly, agency cost
theorists posit that firms forfeit control when they cede property ownership
to others. These extreme views are useful in the same way that most
economic theories are useful: they provide a stark background, against
which real-world nuances can be brought into effect.
And in the real world, contracts can be used to reorient governance and
control. A joint venture could agree (perhaps foolishly) that General Motors
makes all the manufacturing decisions Monday, Wednesday, and Friday—
while Toyota takes charge on Tuesdays and Thursdays. A franchise
agreement can mandate that all Big Macs use two hamburger patties and the
special sauce. And a business outsourcing deal can carve out certain highrisk areas and award operating control over these decisions to non-owners.
Contracts are pliant tools.134
134
Indeed, some scholars understand entire corporations simply as a “nexus of
contracts” among the relevant constituencies. Jensen and Meckling put forth this view in
their foundational work on the firm. See Jensen & Meckling, supra note 35. Other work has
also adopted a “nexus of contracts” understanding of the corporation. See, e.g., Hansmann
& Kraakman, supra note 67, at 391-93; Stephen M. Bainbridge, The Board of Directors as
Nexus of Contracts, 88 IOWA L. REV. 1 (2002). The nexus of contracts framework is not
the only way to understand a corporation, of course, and it faces its share of challenges. See
Melvin A. Eisenberg, The Conception that the Corporation is a Nexus of Contracts, and
the Dual Nature of the Firm, 24 J. CORP. L. 819 (1999) (“the nexus-of-contracts
conception is unsatisfactory … in part because the corporation has a dual nature [of
reciprocal arrangements and bureaucratic hierarchy]”); Iacobucci & Triantis, supra note 9,
at 569 (“[A] corporation is more than a nexus of contracts or group of assets; it has the
legal rights and obligations of a person.”); Margaret M. Blair & Lynn A. Stout, A Team
Production Theory of Corporate Law, 85 VA. L. REV. 247 (1999).
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George S. Geis
[15-Feb-08
Furthermore, the activity within this netherworld between markets and
hierarchies seems to have become much more varied and interesting (and
complicated) in recent years. Let me start by briefly examining the
syndication experiment in corporate finance—and then ask whether
something comparable may be emerging with operational projects on the
left side of the balance sheet.
A. The Syndication Experiment in Finance
These are interesting times in the world of corporate finance.
Historically, a firm’s choice of fundraising centered primarily around
simple debt or equity instruments. To be sure, intermediate vehicles, such as
convertible debt or preferred stock, have been around for a while, but these
unorthodox hybrids are uncommon beyond a few specialized contexts.135
More recently, however, financial alchemists in Chicago and resourceful
bankers in New York have concocted a stunning array of synthetic
products—that increasingly allow firms and investors to slice up and
repackage financing risk and reward into customized economic positions.136
In essence, these new instruments allow principals to choose precisely
which strings they want attached to their money. For example, an investor
can purchase a credit default swap, along with an underlying debt position
in a firm, in order to lay off the risk that the company will skirt its
repayment obligations.137 Or synthetic financial investments might be
peeled off from collective pools of assets to mete out nuanced payment
waterfalls and risk positions.138
How exactly do these newer breeds of financial contract work? The
details can grow quite complex, but it is useful to consider a basic example
related to bank lending. Historically, a bank willing to loan money to, say, a
corner grocery store would fork over the cash and account for this outlay by
135
See Triantis & Triantis, supra note 9.
See, e.g., Aaron Lucchetti & Alistair MacDonald, Trading Up: Inside the
Exchanges’ Race to Invent New Bets, Wall St. J. A1 (July 6, 2007) (describing the
expansion of the number and variety of derivative instruments available on the Chicago
Mercantile Exchange and noting that global derivatives trading has grown on average by
30 percent per year since 2001).
137
A credit default swap is a derivative contract where two parties will trade the credit
risk of an independently referenced third party. If the third party fails to repay a loan, for
example, the protected party receives a payment from the swap counterparty to compensate
them for the event of default. See Partnoy & Skeel, supra note 10. Credit default swaps
thus allow investors to concentrate on other risks, such as interest rate swings, which they
may feel more comfortable bearing.
138
See, e.g., Carrick Mollenkamp & Serena Ng, Wall Street Wizardry Amplified Credit
Crisis, Wall St. J. A1 (Dec. 27, 2007) (explaining multiple rounds of asset pooling and
partitioning).
136
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The Space Between Markets and Hierarchies
39
increasing another asset account (reflecting the fact that the grocery store
was eventually obligated to repay the money). The main point, for our
purposes, is that the risk of default, and the rewards of repayment, remained
with the lending bank.
Recently, however, it is more likely that this same bank would
syndicate—or “securitize”—this loan in order to remove it from the bank’s
balance sheet.139 There are at least two general strategies for syndication.
The first is simply to sell the loan (typically in combination with other
loans) as a securitized bond. The second strategy is to “synthetically
securitize” the loan through the use of derivatives. For instance, the bank
might lay off the default risk (with credit default swaps140) and lock in the
current interest rate (with interest rate swaps141). The net effect of either
strategy: the loan is removed from the bank’s books, leaving it free to make
new investments.142 Of course, if the bank wants to retain a narrow slice of
risk—keeping, for example, loans related to the grocery business in a
certain part of town—it is free to order its affairs accordingly.
More generally, finance and legal scholars are starting to question
whether this march toward increasingly complete capital markets is leading
to a situation where working capital is becoming divorced from risk
capital.143 As financiers engineer new strategies for replacing the broad and
untethered risk of equity investments with carefully tailored alternatives, we
may need to rethink the implicit assumption that diversified shareholders
are necessarily the cheapest bearers of risk.144 Myron Scholes, the Nobel
Prize-winning financial economist, first raised this possibility ten years
139
See, e.g., David Roche, The Global Money Machine, Wall St. J. A21 (Dec. 14,
2007) (describing the use of these strategies to increase bank liquidity).
140
See supra note 137.
141
An interest rate swap is another type of financial contract where one category of
future interest payments is exchanged for another. It is often used to trade floating interest
payments for fixed interest payments.
142
See Roche, supra note 139. This assumes, of course, that the structure conforms to
accounting standards governing the removal of the assets from a balance sheet.
143
See Robert C. Merton, Financial Innovation and Economic Performance, 4 J.
APPLIED CORP. FIN. 12 (1992) (discussing the split between working capital, used for
financing firm projects, and risk capital, which bears the ultimate results of such efforts);
Gilson & Whitehead, supra note 10, at 3 (discussing the notion of increasingly complete
capital markets as a recent development allowing investors to accept small portions of
risk—instead of “broadband” equity risk).
144
See Gilson & Whitehead, supra note 10. It is also worth exploring the extent to
which these products create additional agency distortions. For instance, syndicated debt
originators may lose incentives to negotiate contractual protections against agency abuses
if they will promptly carve up the debt into new products and offload different tranches of
this debt to scattered groups of investors. Recent turmoil in the credit markets suggests that
these problems may indeed be significant. E.g., Mollenkamp & Ng, supra note 138.
40
George S. Geis
[15-Feb-08
ago,145 and Ron Gilson and Charles Whitehead have recently explored it in
relation to corporate governance.146 Douglas Baird and Todd Henderson
have also considered similar themes in their work on the appropriate scope
of fiduciary duties and investor disclosure obligations.147
It is important to note, however, that this financial development has both
advantages and disadvantages. As recent market events have demonstrated,
innovation along these lines can mutate into new demons.148 For example,
the additional layers of complexity and opacity in these contracts can veil
incentives and results—thereby generating new economic distortions.149
When the rules change, creative parties can often find both good and evil
ways to play the new game—and some financial Frankensteins have surely
awoken. My point is simply that financing has become much more flexible
and complicated in recent years.
In any event, we are only starting to understand these shifting
dimensions of risk, control, ownership, and commitment, and my purpose
here is not to explore the likely evolutionary path of corporate finance in
any level of detail.150 I only wish to note the trend towards increasingly
complete capital markets as a reference point. For my real question is
whether something similar may also be occurring with respect to a firm’s
operational alternatives.
In other words, it is worth considering whether the recent kaleidoscope
of financing alternatives may be only half of the story. For just as
investment inputs can be tailored through increasingly complex contracts,
operational outputs might also be aggregated or apportioned between
different legal entities. The rewards of ownership can be shared through
145
See Myron S. Scholes, Derivatives in a Dynamic Environment, 88 AMER. ECON.
REV. 350, 366 (1998).
146
Gilson & Whitehead, supra note 10. The authors speculate that stock may
ultimately morph into a “management incentive contract” if diversified equity holders no
longer represent the cheapest supply of capital (though they ultimately doubt that all
financing will take the form of risk-managed variants on debt—as there will likely be
situations where diversified equity remains the best source of funds). Id.
147
Douglas G. Baird & M. Todd Henderson, Other People’s Money, 60 STAN. L.
REV. (forthcoming 2008) (discussing the appropriate scope of fiduciary obligations and
corporate disclosure requirements in light of recent capital market developments).
148
One example is the incremental agency cost problem arising through loan
origination and rapid resale. See, e.g., Henry T.C. Hu & Bernard Black, Debt, Equity, and
Hybrid Decoupling: Governance and Systematic Risk Implications, EUROPEAN FIN.
MGMT. (forthcoming 2008), available at http://ssrn.com/abstract=1084075 (describing
this and other unpleasant circumstances surrounding financial disintermediation).
149
Id.
150
Indeed, recent turmoil in the credit markets cautions against bold predictions on the
future course of financial investments. We may, in fact, see a return to basic investing tools
until the financial markets can work out the supporting mechanisms needed to manage
increased contractual complexity.
15-Feb-08]
The Space Between Markets and Hierarchies
41
incentive compatible compensation clauses that divide the spoils (or pain)
of ex-post outcomes. Likewise, risks associated with outcome variability
might conceivably be run through a contractual meat-grinder to be parsed
(or pooled) between multiple parties.151 Or, said another way, residual
owners may not always be the logical parties to exercise ultimate control
over certain uses of operational assets.
Indeed, this sort of operational flexibility has been discussed before—by
an infamous energy firm in Houston responsible (at least indirectly) for
transforming corporate law around the globe. I cannot think of three words
more likely to startle corporate law scholars than “Enron was right.”
Nevertheless, this is exactly the contention I am now about to make.
B. Was Enron Right?
Let me quickly clarify—before you toss the rest of this article (and I
toss my academic reputation) into the wastebasket. I am not referring to the
ethical lapses, lies, theft, or criminal fraud perpetrated by Enron and its
employees. These were, of course, reprehensible. Nor do I believe that
Enron was right with respect to the tactical execution of its business
strategy. Others have clearly documented how the firm got in way over its
head by making deals it did not understand and by failing to erect firm-wide
systems and controls for governing its affairs.152 My argument is simply
that Enron’s high level strategy, its vision of the way that economic
production would eventually be organized, may have been quite prescient.
What, then, was Enron’s grand theory of economic organization? In a
nutshell, the top managers at this troubled energy firm believed that
ongoing market pressures, combined with falling interaction costs, were
leading to a world where supply chains would be splintered into atomistic
subcomponents and parceled out among many different owners. Or, in other
words, that we are moving toward an increasingly complete spectrum of
operating structures.
The easiest way to understand this argument is to reconstruct a simple
value chain, representing the sequential flow of goods and services from
raw states into finished products.153 As Figure 3 illustrates, two broad
151
The possibilities here have been discussed frequently in relation to financial
derivatives and syndicated investment products—but much less so in the operating context.
152
See, e.g., John C. Coffee, Jr., What Caused Enron? A Capsule Social and Economic
History of the 1990s, 89 CORNELL L. REV. 269 (2004); Jeffrey N. Gordon, What Enron
Means for the Management and Control of the Modern Business Corporation: Some Initial
Reflections, 69 U. CHI. L. REV. 1233 (2003). For an entertaining popular press account of
Enron’s shortcomings, see KURT EICHENWALD, CONSPIRACY OF FOOLS: A TRUE
STORY (2005).
153
The use of value chain analysis dates back to Michael Porter’s seminal work on
42
George S. Geis
[15-Feb-08
categories of costs must then be incurred at each stage: the transformation
costs required within each step to boost goods or services closer to their
finished state, and the interaction (or transaction) costs154 required to
coordinate and hand off the activity to the next phase of production. For
example, in order to make a car, manufacturers must harvest rubber trees
into rubber, transform rubber into tires, assemble tires onto axles, and so on.
The sum of transformation costs (at each stage in the value chain) and
transaction costs (from moving between stages) will represent the total cost
of production. And, obviously, the ability to sell the good or service for any
amount in excess of this cost total is what generates economic surplus.
LAN020213287-23884-ZXK
Figure 3. Simple Value Chain
1.0
1.0
1.0
.90
Transformation
Interaction
Finished
Product
.85
Transformation Interaction Total
Costs
Costs
Costs
.90
3.45
3.00
6.45
.80
Finished
Product
.95
.20
1.10
.20
1.20
.20
1.10
Transformation Interaction Total
Costs
Costs
Costs
4.35
.60
4.95
Historically, interaction costs were thought to be lower when activity
moved internally from one step in a value chain to another (portrayed as the
bottom chain in Figure 3)—instead of passing via contracts between distinct
legal persons (portrayed in the upper part of the figure). Thus the Ford
Motor Company famously owned the rubber tree forests used to make the
tires on its Model T. Similarly, the retailer 7-Eleven kept cows to produce
strategy; this framework is commonly employed in management decisions. See MICHAEL
E. PORTER, COMPETITIVE ADVANTAGE: CREATING AND SUSTAINING SUPERIOR
PERFORMANCE (1985).
154
These costs should be viewed broadly, in the manner described above, as
representing all barriers to the movement and efficient use of assets. See infra Part I.A.
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The Space Between Markets and Hierarchies
43
the milk that it would pasteurize, bottle, and sell in its stores.155 This
vertical integration made perfect Coasean sense in a world where
transaction costs were significant across markets, but more modest within
internal hierarchies.156
Yet, in Enron’s view,157 two fundamental changes were starting to take
place as external transaction costs began to drop (relative to the internal
costs of navigating hierarchies) in response to technological improvements,
faster communication networks, falling trade barriers, and the like. First,
firms would need to rethink the calculus of bundling most value chain
activities within their corporate borders. Second, the value chains
themselves were likely to shift, as innovators capitalized on new ways to
sequence, organize, and own the factors of production.
How, then, should a firm compete in this brave new world? Broadly
speaking, there are at least three options. First, managers might continue to
maintain legal control over most parts of a value chain. This may make
sense in some industries, but it will likely prove much more expensive to go
to market this way in others.158 A second strategy is to focus on only one
part of the value chain. Again, this approach has appeal for some firms, but
competition may become fierce in increasingly global markets. A firm
would have to be among the most competitive vendors in the world to
generate substantial profits through that particular slice of activity.
155
See Mark Gottfredson et al., Strategic Sourcing: From Periphery to the Core,
HARV. BUS. REV., Feb. 2005 (describing 7-Eleven’s historical strategy).
156
See supra Part I.A.
157
And, to be sure, Enron was not the only turn-of-the-century prophet proclaiming
these emerging seismic fissures. See, e.g., LOWELL BRYAN ET AL., RACE FOR THE
WORLD: STRATEGIES TO BUILD A GREAT GLOBAL FIRM (1999).
158
To illustrate this with the hypothetical numbers of Figure 3, imagine that an
industry has four steps in the value chain. A vertically integrated firm can take the product
to market by incurring the following transformation costs: step 1 = 0.95; step 2 = 1.1; step
3 = 1.2; and step 4 = 1.1. Imagine further that it has historically cost the firm 0.2 in internal
transaction costs to move between each step in the value chain. Thus the fully integrated
firm can bring the product to market for a total of 4.95 (4.35 in transformation costs plus
0.6 in transaction costs). This approach may have compared favorably in the past to a nonintegrated strategy, under which each stage of transformation is likely to be cheaper
(because of market pricing pressure) but transaction costs are likely to run higher.
Continuing the example, suppose that a firm seeking to stitch together an external, marketbased value chain would incur transformation costs of 0.9, 0.85, 0.8, and 0.9 (for the four
steps) and transaction costs of 1.0 (between each step). The total cost of going to market in
this case would run 6.45 (3.45 in transformation costs plus 3.0 in transaction costs) and be
far more expensive than internal ownership. If, however, external transaction costs drop to
0.1, then the total cost of production through outside sourcing plunges to 3.75 (3.45 in
transformation costs plus 0.3 in transaction costs). Under these illustrative assumptions,
firms that continue to compete through internal hierarchy will face a significant cost
disadvantage.
44
George S. Geis
[15-Feb-08
The third strategy—and the one pursued (at least in theory) by Enron—
is to focus neither on a fully-integrated value chain nor on a vertical slice of
that chain, but rather to compete in the intermediate spaces. In other words,
a company following this strategy would work to streamline the ability of
other firms to take advantage of falling interaction costs by helping them
find new ways to slice, dice, and trade operational risk and reward. They
may, for example, try to create new markets or new structures for pooling
and syndicating operational risk. This sort of strategy is analogous, then, to
one pursued by large banks looking to aggregate and repackage financial
instruments as a way to offer new products, and customized risk profiles, to
borrowers and investors.
Enron ultimately failed spectacularly at this endeavor—in part because
it was difficult for employees to translate such a lofty vision into pragmatic
business plans.159 But it is intriguing to ask whether Enron’s bold view of
the future may have nevertheless been quite perceptive. For at the exact
same time that the Houston energy firm’s stock was plummeting from the
pinnacle of Wall Street to the gutters of history, other companies began
experimenting with new strategies for disaggregating their value chains via
outsourcing.
Suppose that Enron was right. What is this likely to mean for the legal
ownership of operational risk?
C. Implications of More Complete Operational Structures
If we are indeed entering a world where falling transaction costs are
presenting firms with more granular organizational choices (and while there
is anecdotal evidence of such change,160 I will certainly attempt no
empirical proof of the matter), then what would be the effect of widened
access to this space between markets and hierarchies? Let me briefly
hypothesize on three possible paths forward: synthetic risk management,
reshuffled value chain ownership, and a backlash toward simplicity.
The first possibility is that organizational divisions will remain much as
they are—but firms will use a more complex web of contracts to
synthetically manage operational risk. In other words, a firm’s assets may
largely remain in its existing legal body, even if the economic risk tied to
159
For example, one way that Enron sought to implement this strategy was by
constructing new markets for trading operational risk—both in its traditional lines of
business (long term energy), as well as in less familiar industries such as broadband and
weather. Yet problems soon arose when Enron was unable to fully comprehend the risk
positions it was taking in these ventures—and the firm soon morphed from a neutral market
maker into a highly leveraged principal with major bets on future industry events. Things
then got ugly when it lost these bets. See sources cited supra note 152.
160
E.g., BRYAN ET AL., supra note 157.
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The Space Between Markets and Hierarchies
45
the performance of these assets increasingly crosses over to impact different
entities. A firm can, for instance, already take contractual positions that hive
off and transfer the risks of commodity price swings, inflation, or general
economic downturns—thereby concentrating on the specific uncertainties
that they feel best suited to manage.161 It is possible that these synthetic
contracts will continue to grow in scope and complexity, offering a more
complete basis for managing (or magnifying) operational risk without the
need to worry about which legal entity owns which assets.
Suppose, for example, that I own an umbrella manufacturing company.
My profits from year to year depend on a host of different factors, including
the weather, the overall economy, the price of raw materials, and the cost of
labor. Yet in a world with robust operational contracting, I might hedge
against most of these effects—while retaining the exact same physical
assets and operating procedures inside “Umbrellas Inc.” I will buy weather
derivatives that pay off during long periods of sunshine, a contract tied to
the general health of the economy, a position to offset increases in labor
costs, and so on. If I can successfully hedge these major risk points, then my
results may ultimately reflect only the ability to manage and coordinate the
production process—operational risks that I might feel quite comfortable
accepting. And, importantly, all of this occurs without significant change to
the size or quantity of physical assets within my firm.
A second possible scenario is that falling interaction costs will splinter
industry value chains, leading to much more profound organizational
change. In other words, the space between markets and hierarchies (or
really, the use of this space) may expand as the relative cost advantages of
atomistic contracting become more compelling.162 From a legal point of
view, this would mean that the control and ownership of assets could
effectively become apportioned among diverse legal entities through more
nuanced contracts.163 If so, it may become increasingly difficult to untangle
161
See Gilson & Whitehead, supra note 10.
Of course, as described earlier, falling interaction costs do not automatically mean
that firms are better off moving the activity out of their corporate control: they might still
engage in captive offshoring. The real question is whether these changes are creating
relative cost advantages in the expenses that must be incurred via contractual transactions
and those maintained within the firm. This is ultimately an empirical question, but firms
will likely find it difficult to maintain cost advantages in all localities—suggesting that
interaction costs may drop more rapidly outside a firm than inside it. For preliminary
evidence of this, see Jackie Range, Rethinking the India Back Office, Wall St. J. A6 (Feb.
11, 2008) (describing a report by McKinsey & Co. and the India policy consortium
NASSCOM finding that captive offshoring centers cost 30 percent more than outsourced
offshoring centers for some type of work). Relative cost advantages may also be explaining
recent interest in the sale or spin-off of some captive centers.
163
Such a development would also raise interesting agency law questions akin to those
underlying the problem of lender liability. See, e.g., Daniel R. Fischel, The Economics of
162
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the precise operational risks owned by an economic entity at any given
moment in time.
Practically, this would mean that firms facing shifting pressures on their
value chains—and on the optimal sequencing of economic activity164—
might turn to an increased use of outsourcing (or other shared contractual
strategies) to support changes in production. Such a strategy could provide
firms with additional flexibility or allow them to rapidly alter a faltering
business model. (Indeed, the focus of outsourcing deals is increasingly
turning from “lift and shift” endeavors toward strategic efforts to “transform
and shift.”165)
It is worth noting that outsourcing vendors may resist contractual
attempts to wrest control of their activity (or, alternatively, they may
demand higher prices in exchange for these concessions). It is more difficult
to run a complex outsourcing business when your hands are tied by
contractual provisions limiting employee mobility, the use of different real
estate and technology assets, and cumbersome approval rights. Moreover,
these provisions can also have negative implications for employee morale;
some managers resent being shackled to one client’s project for all of
eternity. Any given relationship will likely depend on many factors—and
we might expect control to ultimately be sliced, diced, and aggregated in
diverse combinations.
Under this view of the world, then, legal ownership of assets could
change more dramatically as industries outsource, splinter, re-sequence, and
recombine the puzzle pieces of economic production. It does not necessarily
mean that legal entities will become smaller. Indeed, there may be reasons
for some large corporations to specialize in narrow areas of production to
generate economies of scale that allow them to bear slivers of operational
risk more efficiently than anyone else. Other bold aggregators might find it
sensible to gather and syndicate operational risk across larger patches of
industry. The main point is that asset ownership and economic activity
might reside more in a netherworld between markets and hierarchies—such
that legal title may not mean as much as it has in the past.
Finally, there is a third possible scenario that is much easier to
articulate: a backlash toward simplicity. By this, I mean that innovations in
Lender Liability, 99 Yale L.J. 131 (1989). More generally, there is a potential risk that a
counterparty assuming significant control over the use of assets may be legally responsible
for third party tort claims. I am not aware of any lawsuit along these lines in the offshore
outsourcing context, but it would be worth examining the issue in more detail.
164
As firms are able to access cheaper labor, for example, they may de-emphasize the
use of capital investments, or reorder activities in a way that allows for more intensive use
of existing capital. See Farrell, supra note 101.
165
See, e.g., Jessica Twentyman, Transformation is the First Step in Outsourcing, FIN.
TIMES, Oct. 3, 2007, at A6.
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The Space Between Markets and Hierarchies
47
economic organization might lead to new frustrations—and operational
perils—such that firms will revert to simpler, vanilla supply contracts.
Indeed, there is strong evidence that this regression is taking place on the
financing side of the balance sheet (as of early 2008). Synthetic financing is
rapidly losing favor, and firms seeking to raise new capital are returning to
the most transparent forms of debt and equity. It is possible that something
similar may occur with respect to operational activity, at least for some
period of time.
No matter which (if any) of these scenarios emerges, firms will
undoubtedly place a greater premium on risk management. It will become
increasingly important to develop managerial prowess and technological
controls clever enough to plumb the depths of complex operational
networks and gather relevant information. Beyond this, however, it is
difficult to make meaningful predictions about how shifting value chains
will ultimately impact the organization of economic production, and I offer
these ideas only as very preliminary thoughts on the matter.
IV. EMPIRICALLY ASSESSING OUTSOURCING
But enough of the mile-high theorizing. The only way to test whether
outsourcing really serves as a governance compromise—and not just as a
straightforward cost-cutting device—is to return to the empirical project in
hybrid contracting.166 I want to conclude, therefore, with a discussion of
how outsourcing can be subjected to empirical assessment—along with
some thoughts on the goals that can realistically be accomplished with this
work.167 [Note: this section is a work in progress, and I particularly
welcome feedback on these ideas]
In my view, there are two fruitful areas of inquiry. The first (and more
modest) project involves conducting a positive assessment of the key
features governing outsourcing relationships. In other words, it is necessary
to undertake a contractual coding exercise to determine exactly how parties
have structured their operational partnerships. A detailed collection and
synthesis of these variables, across a diverse range of settings, would be
useful in its own right—and is also a prerequisite for more ambitious work
to test theoretical claims.
What variables should be captured? The analysis should link back to the
theoretical rationales for outsourcing. For example, basic term and pricing
information (including incentives) will be required to estimate the cost
savings from outsourcing. Terms granting client control rights—such as
166
For the basic premises, objectives, and challenges of this work, see supra Part I.D.
Data collection for this project is currently underway; full empirical results will be
presented as subsequent work.
167
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manager appointment clauses, manager termination clauses, business
process authorization rights, mandatory training procedures, and other
forms of direct control—should be coded in relation to the hold-up and
agency problems. Similarly, other contractual efforts to mitigate agency
distortions should be noted. This includes terms like detailed service level
commitments, third party monitoring obligations, and liberal “for
convenience” exit rights. Finally, a number of other control variables might
be specified (such as industry, scope of work, project size, presence of legal
counsel, geographic location of work, and project date).168
Armed with this positive data, the second empirical task is to assess
whether key differences in outsourcing contracts can be explained by the
predicted dependent variables. In short, does outsourcing really work as a
theory of governance compromise? To do this, it is necessary to collect
additional information (or proxy variables) on the most important dependent
terms: the degree of relation-specific assets, intensity of agency risk, asset
heterogeneity, and so on. The “easier” way to do this is by forming
hypotheses about different types of outsourcing relationships.169 For
example, call center outsourcing is arguably more standardized than IT
outsourcing—and thus subject to less agency risk. Other types of
outsourcing projects might be stratified in this same manner. The more
difficult approach is to gather detailed industry and firm-related information
linked to these dependent variables. For example, outsourcing managers
might be surveyed on questions related to asset specificity or agency risks
underlying their projects.
The final step is to run econometric models testing whether observed
differences in outsourcing contracts can be explained by these dependent
variables. It would be powerful to conclude, for instance, that an industry
with high levels of relation-specific assets (perhaps, financial services) uses
more intense governance provisions170 in its outsourcing projects
(everything else being equal) than a standardized industry (perhaps,
168
It may also be important to broaden this analysis into captive offshoring projects in
order to avoid selection bias.
169
Such an approach would be analogous to other empirical work on hybrid ventures.
See Oxley, supra note 87.
170
There is one other issue to finesse: exactly what does it mean to have “intense
governance provisions.” Again, there is an “easier” and a “harder” way to parse this
independent variable. The easier way involves building high-level composites of the
various governance terms observed in the positive analysis of contracts. For instance, I
might take a “totality of the circumstances” approach by dividing control provisions into
three categories (intense, moderate, and light) and then analyzing whether the dependent
variables explain why contracts sort into each bucket. The harder (but perhaps more
objective) way to proceed is to determine the presence of each critical governance term in
relation to the measured dependent variables.
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The Space Between Markets and Hierarchies
49
transportation). Ultimately, then, this empirical work will yield evidence
about the circumstances where hybrid outsourcing does indeed serve as a
form of governance compromise. Or it will suggest that these factors may
not carry much water in the real word.
[more detailed discussion to come during workshop presentation]
CONCLUSION
For the past several decades, legal scholars have focused much of their
attention on two stark alternatives for organizing operational activity. On
the one hand, a firm can retain the factors of production within its corporate
borders in order to cut transaction costs and maintain hierarchical control
over future uncertainties. On the other hand, it may purchase the necessary
inputs through market exchange to garner lower prices or reduce agency
cost distortions. In this article, I have argued that it is worthwhile to move
beyond this bifurcated model of production by digging into the more
nuanced contractual activity that comprises the space between markets and
hierarchies. For, in reality, firms will sometimes seek to organize economic
production within hybrid entities in order to compromise on the various
factors underlying firm governance.
More specifically, I have examined the recent rise in complex business
outsourcing transactions to illustrate how firms might balance four
fundamental variables. Outsourcing allows firms to recapture some of the
market pressure on input prices. It offers partial protection against the holdup and agency cost problems. And it can help firms craft more granular
capital structures. These benefits will usually come with a price, but
compromise can nevertheless offer a theoretically sound equilibrium under
the right circumstances.
Ultimately, however, these outsourcing transactions must be subjected
to detailed empirical analysis to determine whether this governance
compromise plays much of a role in the decision to pursue these
relationships.
[to be completed]
Finally, I have also pondered a more abstract possibility: that the same
forces facilitating global trade are also making it easier for firms to access a
complete continuum of organizational forms. If this is indeed true, we might
expect to see ongoing innovation in the way that firms shuffle current value
chains, combine and syndicate economic production, and customize legal
relationships. Just as recent changes in capital markets and corporate
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finance have roiled the strategies used by firms to raise capital, corporations
may increasingly look to new options for parsing and pooling operational
risk and reward. Despite the bold predictions of Enron, we are not yet in a
frictionless world. But legal scholars should keep a watchful eye on the
possibility that atomistic contractual compromise may begin to eclipse both
captive corporate ownership and simple market exchange across wider
swaths of our economy.